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**UNITED STATES SECURITIES AND EXCHANGE COMMISSION****WASHINGTON, D.C. 20549**

**FORM 10-K**

| x                                                                                                                                                            | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**     |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|
|                                                                                                                                                         |                                                                                        |
| **For the fiscal year ended December 31, 2006**                                                                                                              |
|                                                                                                                                                         |                                                                                        |
| **OR**                                                                                                                                                       |
|                                                                                                                                                         |                                                                                        |
| o                                                                                                                                                            | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGEACT OF 1934** |
|                                                                                                                                                         |                                                                                        |
| **For the transition period from                    to** |

**Commission file number:****1-32577**

| **BabyUniverse,   Inc.**                                 |
|----------------------------------------------------------|
| *(Exact name of Registrant as specified in its charter)* |

| **Florida**                                                     |   | **65-0797093**                           |
|-----------------------------------------------------------------|--------|------------------------------------------|
| *(State or other jurisdiction of incorporation ororganization)* |   | *(I.R.S. Employer   Identification No.)* |
|                                                            |   |                                     |
| **150 South U.S. Highway One, Suite 500 Jupiter, Florida**      |   | **33477**                                |
| *(Address of principal executive offices)*                      |   | *(Zip Code)*                             |

| **Registrant’s telephone number, including area code:** |
|--------------------------------------------------------------|
| **(561) 277-6400**                                      |

**Securities registered pursuant to Section 12(b) of the Act:**

| **Title of Each Class**             |   | **Name of Each Exchange on Which Registered** |
|-------------------------------------|--------|-----------------------------------------------|
| Common Stock, $0.001 Par Value |   | The Nasdaq Capital Market                     |

**Securities registered pursuant to Section 12(g) of the Act:**None

Indicate by check mark if the registrant is a well-known seasoned issuer, asdefined in Rule 405 of the Securities Act.

| Yes  o | No  x |
|------------------|-----------------|

          Indicate by checkmark if the registrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act.

| Yes  o | No  x |
|------------------|-----------------|

          Indicate by a checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

| Yes  x | No  o |
|------------------|-----------------|

          Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K orany amendment to this Form 10-K.    o

          Indicate by a checkmark whether the registrant is a large accelerated filer, an accelerated fileror a non-accelerated filer:  

|   | Large Accelerated   Filer   o | Accelerated Filer   o | Non-Accelerated   Filer   x |   |
|--------|----------------------------------------------|--------------------------------------|--------------------------------------------|--------|

          Indicate bycheck mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

| Yes  o | No  x |
|------------------|-----------------|

          The aggregate marketvalue of shares of the registrant’s common equity held by non-affiliates ofthe registrant based upon the closing price of such shares on The Nasdaq CapitalMarket as of the last business day of the registrant’s most recent secondfiscal quarter was approximately $23,600,000. 

 As of March 20, 2007 theregistrant had 5,686,470 shares of common stock outstanding.

**DOCUMENTS INCORPORATED BY REFERENCE**

          None

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**PART I**

| **ITEM 1.** | **BUSINESS** |
|-------------|--------------|

*As used in this report, the terms “we,” “us,”“our,” the “Company”, and “BabyUniverse” refer toBabyUniverse, Inc. and its subsidiaries, unless otherwise expressly stated orthe context otherwise requires.*

**Introduction**

          BabyUniverse is aleading Internet content, commerce and new media company in the pregnancy, babyand toddler marketplace.  Through its websites BabyUniverse.com andDreamtimeBaby.com, the Company is a leading online retailer of brand-name baby,toddler and maternity products in the United States.  Through its websitesPoshTots.com and PoshLiving.com, the Company has extended its offerings in thebaby and toddler market as a leading online provider of luxury furnishings tothe country’s most affluent female consumers.  Through its websitesPoshCravings.com, ePregnancy.com and the recently introduced BabyTV.com,BabyUniverse has also established a recognized platform for the delivery ofcontent and new media resources to a national audience of expectant parents.

          BabyUniverse ispursuing a dual strategy of organic growth and acquisition growth that isdesigned to establish BabyUniverse as the leader in the online baby marketplace.Beyond the baby segment, the Company intends to leverage its efficient andgrowing e-commerce platform to acquire other female-oriented e-commerce,marketing and new media companies. The overall objective of BabyUniverse is toestablish a market-leading e-commerce and new media business focused on thehigh-growth female marketplace.

          To further thisobjective, our stock began trading on The Nasdaq Capital Market on March 27,2006, after trading on the American Stock Exchange since August 3, 2005. At thesame time, we changed our trading symbol from “BUN” to“POSH.”  We believe this change is more reflective of ourstrategy to appeal to a broader female marketplace by leveraging our stronge-commerce business model with e-content and new media initiatives focused onthis country’s most affluent online female consumers. 

          We were incorporatedin Florida on October 15, 1997, as Everything But The Baby Inc. andinitially operated the domain name *www.everythingbutthebaby.com.* In 1999,we began to market our products under the BabyUniverse brand at*www.babyuniverse.com*, and we changed our corporate name to BabyUniverse,Inc. on November 16, 2001.  

          We believe that weare one of the largest online retailers of baby, toddler and maternity productsin terms of product offerings and revenues. As an industry leader, we have grownour business internally since inception by increasing our presence in what wehave identified to be the largest and most efficient Internet shopping portals,as well as through search engine marketing, resulting in increased traffic toour websites. We have also attempted to improve our sales conversion rate bybroadening our product offerings and by actively managing the placement of thebest-selling products on our websites.

          The market foronline retailers offering baby, toddler and maternity related products is highlyfragmented, with a significant number of small competitors representing asignificant percentage of total segment sales. We believe that our seasonedsenior management team and our scalable business architecture make uswell-suited to acquire both large and small industry competitors. As part of ouracquisition strategy, we intend to preserve the goodwill and marketingrelationships of acquired companies as necessary to maintain and grow marketshare. In addition, we may acquire companies that market products predominantlyto women over the Internet, or companies that enhance our ability to marketproducts to women.

          Our e-commerceofferings include over 35,000 products from over 600 manufacturers that arepresented in easy-to-use online shopping environments that include baby, toddlerand maternity accessories, apparel, bedding, furniture, toys and gifts. Theseproducts are available in a variety of styles, colors and sizes which accountfor over 750,000 stock keeping units (“SKUs”). We also provide expertbuyer’s guides and product descriptions to assist our customers withfinding quality products and to help parents make informed decisions about theirbabies’ and toddlers’ needs and safety.  

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**Growth Strategy**

          The overallobjective of BabyUniverse is to establish a market-leading e-commerce and newmedia business focused on the high-growth female marketplace. Beyond the babyrelated e-commerce segment, the Company intends to leverage its efficient andgrowing e-commerce platform to acquire other female-oriented e-commerce,marketing and new media companies.  We intend to achieve this objective bypursuing a balanced growth strategy that contemplates both organic and externalgrowth initiatives. Our organic growth strategy will focus on initiatives thatwill build on our existing business strengths while our external growth strategywill focus on consummating strategic acquisitions of companies focused on thehigh-growth female marketplace. 

***Organic Growth Strategy***

          We intend to pursuevarious initiatives associated with our organic growth strategy that aredesigned to enhance our market presence, expand our customer base and provide asuperior online baby, toddler and maternity shopping experience. Key elements ofour organic growth strategy include the following: 

*          BuildBrand Recognition.* We will continue taking steps to have our websites appearamong the first several websites naturally listed in search engine results. Wewill also continue to build our brands primarily through online marketing andadvertising. These efforts currently consist largely of the purchase of keywordsfrom large search providers, such as Google, Yahoo and MSN, which result inadvertisements for our websites being displayed next to search results. Inaddition, we also aggressively participate in many of the major online shoppingportals such as Shopzilla, Amazon, MSN Shopping, and Shopping.com. Most of ouradvertising expenditures are on a ‘pay for click’ basis, and smallerportions are based on negotiated rates or percentages of sales. We haveestablished and are continuing to develop brands based on trust, guidance andvalue, and we believe our customers view BabyUniverse as a trusted authority onbaby, toddler and maternity products. Our goal is for consumers to seek theBabyUniverse and our other brands and consistently revisit our websites wheneverthey purchase baby, toddler and maternity products. 

*          Improve Our SalesConversion Rate.* As we have hundreds of thousands of visitors to ourwebsites each month, small changes in the conversion rate, or the percentage ofvisitors to our websites who make a purchase, can have a significant impact onsales. In many of our marketing programs, we incur expenses based on the numberof people that click on advertisements that link them to our websites. Whencustomers click on these advertisements and do not consummate a purchase, weincur expense but do not generate immediate sales. We believe that we canimprove our sales conversion rate by offering a wider range of products and byactively managing the placement of our best-selling products on our websites. Wealso believe that by offering a wider range of products we decrease thelikelihood that customers will leave our websites to continue their shoppingelsewhere.

*          Focus on theCustomer Experience to Build Customer Loyalty.* We continue to refine thecustomer service we provide in every step of the purchase process, from ourwebsites to our customer support and fulfillment operations. The customerexperience is designed to empower our customers with knowledge and confidence asthey evaluate, select and purchase baby, toddler and maternity products. Weintend to continue to allocate significant resources to the development andexpansion of our customer service function. These efforts are focused onpromoting customer loyalty and building repeat purchase relationships with ourcustomers. 

*          IncreaseOur In-House Fulfillment of Best-Selling Products.* In January 2006, weopened a 23,000 square foot distribution center in Las Vegas, Nevada to replaceour much smaller warehouse in Ft. Lauderdale, Florida.  We generally incurlower overall costs on those products we process through our warehouse, as ourin-house distribution costs are lower than markups imposed by our distributionpartners or drop shippers. We believe that our distribution center allows us toincrease our product volume in support of our rapid growth in sales.  As weidentify our best-selling products, which represent low inventory capital risk,we selectively make bulk inventory acquisitions to take advantage of thesein-house efficiencies. We believe that expanding our in-house distributionvolume of these best-selling products will allow us to increase our grossmargins. 

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*          ExploreAdditional Marketing Channels.* Although almost all of our marketing presenceis online, we will continue exploring innovative methods of reaching additionalpotential customers through offline marketing initiatives. Many forms of offlineadvertising, such as print advertising in magazines, require large initialexpenditures. Furthermore, it is difficult to track the number of customersgenerated from these types of advertisements. We intend to seek other forms ofpartnered offline advertising. Our plans include minimizing or eliminating theneed for large initial expenditures either by sharing marketing expenses withmanufacturers or by offering joint promotions in concert with our advertisingpartners. 

***External Growth Strategy***

          While our historicalgrowth through 2005 had been primarily organic, we initiated a growth strategyin 2006  based on a balanced combination of organic growth and externalgrowth. We expect that our external growth strategy will be characterized bystrategic industry acquisitions of e-commerce, marketing and new media companiesthat are broadly focused on the high-growth female marketplace. Accordingly, weintend to leverage the skill sets of our management team and board of advisorsand our scalable business architecture to actively evaluate potential e-commerceand content focused acquisition candidates and consummate merger and acquisitiontransactions as an important and on-going component of our business model.

          *Impact of theYear 2000 Downturn.* In the late 1990’s, capital markets were highlyreceptive to technology companies, including e-commerce companies that enjoyedready access to capital at attractive valuations. In the ensuing period ofextreme volatility in e-commerce company valuations, however, very fewe-commerce companies were able to raise capital in either public or privatemarkets. It is important to realize that this market downturn represented asharp decline in valuations only, not a decline in overall e-commerce businessactivity. The e-commerce industry grew quickly during and since this period, asconsumers have migrated more and more from traditional retail points-of-purchaseto the Internet. 

          In spite of theperceived lack of interest by investors, certain types of e-commerce companiescontinue realizing significant growth, a direct reflection of consumers’increasing demands for convenient and secure Internet-based shopping. As aresult of these somewhat contradictory market forces — increaseddemand for e-commerce products against a decreased demand for e-commerceinvestments — many of the e-commerce companies that continue tooperate today have successfully adapted to capital-constrained operating modelsthat require a more conservative balance between growth and profitability thanwas demonstrated by the e-commerce pioneers of the late 1990’s. We believethat we can identify attractive acquisition candidates from within this group ofsurviving market participants. 

          *AcquisitionEnvironment and Prospects.* We have engaged, and expect to continue toengage, in preliminary discussions with prospective acquisition candidates andto continue to develop an analysis of the strategic industry acquisitionlandscape. These discussions traditionally have focused primarily on Internetretailers of baby related products which are smaller than us in terms ofrevenues and content sites that focus on a female audience. These discussionsand analyses suggest the following: 

|   | Growth Capital and Exit Opportunities are Scarce. The positive trends inthe e-commerce industry have not yet resulted in a recognizable increase inprivate equity funding of baby, toddler and maternity online retail companies.Public and private capital markets are generally difficult to access, especiallyfor those companies with inadequate board sponsorship or unproven public marketleadership. Furthermore, as many of these potential targets have not attractedpublic or private investment in recent years, they tend not to have professionalinvestors on their boards of directors or in their management teams. Also, largestrategic acquirers are rarely attracted to developing companies of small size,a characteristic that describes much of the broader baby, toddler and maternitye-commerce industry. |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   | We Possess Characteristics that Make Us an Attractive Acquirer. Based ondiscussions with companies that we have acquired, and preliminary discussionswith potential acquisition targets, management believes that targets will viewour plan as attractive primarily because of the following:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |

|   | • | our sophisticated and seasoned management team and board of directors, who havesignificant experience working for and with companies engaged in substantialacquisition programs; |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

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|   | • | our efficient business model, which is characterized by high inventory turnoverand an ability to rapidly expand product offerings with relatively minimalcapital expenditures; |
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|   |   |                                                                                                                                                                           |
|   | • | our well-defined growth   strategy; and                                                                                                                                   |
|   |   |                                                                                                                                                                           |
|   | • | a visible exit strategy that offers cash or publicly tradedsecurities.                                                                                                         |

          *Structure ofTransactions Contemplated.* We intend to acquire either the equity or theassets of acquisition targets. Depending on the needs of our targets, weanticipate using both cash and stock as consideration for these acquisitions.

          *AcquisitionParameters.* We intend to acquire companies that have the potential forsignificant growth, achievable independently or as a result of cross-marketingstrategies that we implement subsequent to the acquisition. We will focus oncompanies that have exhibited historical profitability or those that can combinewith our company to become profitable. Targeted companies will include directcompetitors with broad product offerings, as well as those that focus on aspecific product niche. Characteristics of targets that we would particularlyvalue include an established strong domain name or brand recognition, matureInternet marketing relationships, stable supplier relationships and defendablemarket positions. 

          *RecentDevelopments. *On March 13, 2007, the Company entered into a definitiveAgreement and Plan of Merger with eToys Direct, Inc.  (See Business –Recent Developments – Strategic Alternatives)  In the event that themerger transaction contemplated by this agreement is consummated, we intend tore-evaluate the Company’s overall external growth strategy in light of theinterests of the combined company.

**Recent Developments**

***Strategic Alternatives***

          On August 14, 2006,BabyUniverse announced that its Board of Directors decided to begin a process toexplore strategic alternatives to enhance shareholder value including, but notlimited to, the acquisition of a substantial private company, the acquisition ofa complementary public company or a potential sale of the Company. On October 5,2006, the Company announced that it had retained Banc of America Securities LLCas its financial advisor.  There can be no assurance that a transactionwill result from this process and the Company does not intend to disclosedevelopments regarding its exploration unless and until the Company’s Boardof Directors has approved a specific transaction.

          On March 13, 2007,the Company entered into a definitive Agreement and Plan of Merger (the“Merger Agreement”) with eToys Direct, Inc. (“eToysDirect”), an e-commerce and direct marketer of toys and other youth-relatedproducts.  Under the terms of the Merger Agreement, which has been approvedby the Company’s Board of Directors, the Company will exchange shares ofits Common Stock, par value $0.001 per share (the “Common Stock”), forall the outstanding shares of eToys Direct.  Immediately following themerger contemplated by the Merger Agreement (the “Merger”),BabyUniverse shareholders at the time immediately prior to the Merger will ownapproximately one-third, and eToys Direct shareholders at the time immediatelyprior to the Merger will own approximately two-thirds, of the outstanding CommonStock.

          The Company andeToys Direct have made customary representations, warranties and covenants toone another in the Merger Agreement.  Consummation of the Merger is subjectto certain conditions, including, among others, the approval of the MergerAgreement by the holders of the Common Stock, the repayment by the Company ofall of its indebtedness for borrowed money outstanding as of the closing of theMerger, and the absence of any law or order prohibiting the consummation of theMerger. The Merger Agreement contains certain termination rights for both theCompany and eToys Direct, and further provides that, upon termination of theMerger Agreement under specified circumstances, the Company may be required topay eToys Direct a termination fee of $1,567,178, and reimburse eToys Direct forthe expenses incurred by it in connection with the transaction in a maximumamount of $1,500,000.

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***Acquisitions***

          On September 13,2005, we acquired all of the shares of outstanding common stock of Huta Duna,Inc., which through the website, DreamtimeBaby.com, is a growing online retailerof brand name baby products that is focused primarily on high-quality beddingproducts.  The Company acquired the shares of Huta Duna common stock inexchange for approximately $6.4 million in cash and 53,165 shares of the CommonStock. 

          On January 13, 2006,through a wholly owned subsidiary (“PoshTots”), we acquiredsubstantially all of the assets of Posh Tots, LLC in exchange for $6.0 millionin cash, a Promissory Note for $6.0 million, 237,248 shares of the Common Stockand warrants to purchase 110,000 shares of the Common Stock at a price of $8.10per share.  Through its primary website, www.PoshTots.com, the Richmond,Virginia-based PoshTots has long been recognized as a leading online retailer ofhigh-end, artisan-crafted furniture to this country’s most affluent newmothers.  Beyond the baby and children’s segments, PoshTots recentlyextended its brand with the Fall 2005 introduction of a new website,www.PoshLiving.com, offering designer quality home furnishings to its existingand growing base of affluent, predominantly female, customers.  In March2006, Posh Tots introduced another new website, www.PoshCravings.com, designedas a content driven initiative targeted at the affluent female customer basealready developed by PoshTots.

          On June 15, 2006,the Company acquired certain assets related specifically to the business ofePregnancy.com and ePregnancy Magazine.  The selected assets acquiredinclude the URL www.ePregnancy.com, the ePregnancy trademark, a related onlinecommunity website, message boards, and an expansive archive of content. Themagazine’s prior owners discontinued publication of ePregnancy Magazine andthe final published issue was distributed in late April as the May 2006issue.  BabyUniverse intends to focus its efforts on growing and supportingthe online community at ePregnancy.com and does not intend to revive themagazine. The acquisition of these assets furthers the overall objective ofBabyUniverse, which is to establish a market-leading e-commerce and new mediabusiness focused on the high-growth female marketplace. 

***BabyTV.com***

          In December 2006 welaunched our flagship new media venture, BabyTV.com, the Internet’s firstintegrated television-style broadcast channel and social networking communityfocused on the needs of new and expectant parents.  BabyTV.com is deliveredthrough an interactive format in which the consumer can tune in tobroadcast-quality live and pre-recorded streaming television, interact throughlive events, respond to synchronized and targeted advertisements, engage ine-commerce transactions, browse links on the Web, and participate inBabyTV.com’s community features, without ever leaving the integratedbroadcast platform. 

          The primary goal ofBabyTV.com, and our other content sites, PoshCravings.com and ePregnancy.com, isto increase revenues from advertisers. We also intend BabyTV.com to build forour e-commerce sites the kind of loyalty with consumers that can be difficult toachieve in a pure e-commerce environment and to become a valuable driver of theBabyUniverse business strategy. 

          BabyTV.com hasalready partnered with the acclaimed women’s media company Oxygen MediaInteractive, Inc., as well as video-on-demand pioneer Alpha Mom TV, Inc., tobring a wealth of informative and entertaining programming to our viewers.Oxygen’s “Oh!Baby” video on-demand (VOD) programming contributessegments of their popular shows, with content celebrating the highs and lows ofparenthood. Alpha Mom contributes a deep catalog of informative programmingfeaturing recognized experts on important topics from pregnancy through earlychild development. We plan to utilize these partnerships to cross-market to the1.7 million monthly unique visitors of BabyUniverse-owned e-commerce propertiessuch as BabyUniverse.com, PoshTots.com and DreamTimeBaby.com, and to contentproperties such as PoshCravings.com and ePregnancy.com.  

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***Amazon Content Agreement***

          In December 2006, wereached an agreement with Amazon.com, Inc. to provide the rich content of ourInternet sites, PoshCravings.com and ePregnancy.com, to Amazon.com consumersthrough the Amazon Baby marketplace. ePregnancy.com, a leading resource for boththe expectant mother and new moms, offers valuable expert information as well asa vibrant online community. PoshCravings.com, launched in March of 2006, hasbecome a top style and trend destination for savvy moms and moms-to-be. Bothsites boast a loyal following of visitors who seek the best advice, tips andtrends as well as fabulous weekly giveaways. 

          Amazon is the firstsignificant strategic relationship designed to support our long-communicatedplan to transform BabyUniverse from a pure e-commerce company into a balancedcontent, commerce and new media concern. With an audience of more than 60million active customer accounts, Amazon presents an opportunity for nationalbrand prominence for our PoshCravings.com and ePregnancy.com contentproperties.

**The Internet Shopping Experience**

          We have designed ouronline retail stores to be the primary source for consumers to purchase baby,toddler and maternity accessories, apparel, bedding, furniture, toys and gifts.We believe our attractive, easy-to-use websites offer consumers an enjoyableshopping experience as compared to traditional store-based retailers. A consumershopping on our websites can, in addition to ordering products, browse thedifferent departments of our stores, conduct targeted searches, view recommendedproducts, visit our Gift Center, participate in promotions and check orderstatus. In contrast to a traditional retail store, the consumer can shop in thecomfort and convenience of his or her home or office. 

          Our efficientwebsite designs and commitment to excellent customer service enable us todeliver a superior shopping experience to consumers, the key components of whichinclude the following: 

          *ConvenientShopping Experience.* Our online stores provide customers with easy-to-useand easy-to-shop websites. They are available 24 hours a day, seven days aweek and may be reached from the shopper’s home or office, or anywhere withInternet connectivity. Our hierarchical website designs and broad search abilitymake our websites easy to navigate and to find specific brands and product types. Duringregular business hours, our customer service is readily available to furtherassist in finding the right product or answering any questions. Our broadproduct selection and extensive distribution network enables us to meet theneeds of our customers located throughout the United States and Canada,especially those in rural or other locations that do not have convenient accessto physical stores. Our gift registries, flexible payment methods, and onlinetransaction security complement our overall convenient shoppingexperience.

          *Extensive ProductSelection and Innovative Merchandising.* We offer a broader selection ofbaby, toddler and maternity accessories, apparel, bedding, furniture, toys andgifts than would be economical or practical to stock in a traditional store forall but our largest competitors. We provide consumers with a comprehensiveselection of both traditional, well-known brands and select specialty brands.The merchandising and/or placement of product on our websites are designed toensure that our customers immediately view the most popular products in eachdepartment. We continually monitor our customer buying habits to determine ourbest-selling products in each category. The most popular products are thenfeatured on our homepage and in various locations throughout the website withthe intent to increase our sales conversion rate. We also suggest complementaryor other related purchases in an effort to cross-sell products across ourdepartments and promote impulse purchases by customers. Finally, our range ofhelpful and useful shopping services, such as our gift registries, enable us todisplay and promote our product selection in a flexible and targeted manner.

          *Personalized GiftRegistry.* Our gift registries permit expectant parents to select the itemsthat they wish to have their relatives and friends purchase and then permit theproducts to be purchased online from anywhere in the world for shipment to theregistrant. We assist the registrants in notifying their relatives and friendsof the registries by either sending an email announcement or by mailing to theregistrants pre-printed invitation card inserts for distribution by theregistrants themselves.

          *EfficientBrowsing Features.* Our websites offer visitors a variety of highlightedsubject areas and special features arranged in a simple, easy-to-use formatintended to enhance product search, selection and discovery. By clicking on thepermanently displayed department names, the consumer moves directly to the homepage of the desired department and can quickly view promotions, bestsellers andfeatured products. Customers can use a quick keyword search in order to locate aspecific product and can also execute more sophisticated searches based onpre-selected criteria depending upon the department. In addition, customers canbrowse specifically designed pages dedicated to products from key nationaland/or specialty brands that we choose to feature.

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          *ComprehensiveProduct Information.* One of the advantages of an online retail store is theability to provide more comprehensive product information and data. On ourwebsites, customers can find detailed product information, including productdescriptions, a list of accessories and related products that are available. Wealso offer buying guides, product comparisons, product specifications andinstruction manuals so a customer can make an informed purchase decision. Wealso encourage customer feedback by allowing our customers to write productreviews. 

          *High Level ofCustomer Service and Support.* A key element of our sales strategy is ourability to provide a high level of customer service and support, including:

|   | • | knowledgeable customer   service;                   |
|--------|--------|-----------------------------------------------------|
|   |   |                                                |
|   | • | product selection services   and advice;            |
|   |   |                                                |
|   | • | online order tracking and   email confirmation; and |
|   |   |                                                |
|   | • | gift-wrapping.                                      |

          We have historicallymaintained our customer service functions in-house instead of outsourcing theseservices. We believe that friendly and responsive customer service is an avenuefor building brand recognition and customer loyalty.  We have evaluatedproviders of outsourced customer service functions and may continue to do so inthe future.  We would only engage the services of an outsourced customerservice provider if we felt that our expectations for a high level of customerservice would be maintained. We believe that attentive, proactive customerservice is an essential component of any e-commerce business model and, inparticular, the baby product market requires superior customer service.Accordingly, we will continue allocating significant resources to thedevelopment and expansion of the customer service function. 

**Fulfillment Operations**

          Currently, wepurchase and fulfill our products to our customers through the followingmethods: 

|   | • | approximately 39% through the combination of our 23,000 square foot Las Vegasdistribution center,  and a third party warehouse and fulfillment center inSt. Louis, Missouri;                                                                |
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|   |   |                                                                                                                                                                                                                                             |
|   | • | approximately 54% via drop ship arrangements with manufacturers and vendors,whereby customer orders that are placed through our websites are sentelectronically to manufacturers or vendors that ship those orders directly toour customers; and |
|   |   |                                                                                                                                                                                                                                             |
|   | • | approximately 7% through a fulfillment agent and a buying consortium, wherebycustomer orders that are placed through our websites are sent electronically tothese entities that ship those orders directly to our customers.                     |

          As part of our organic growth strategy for the past several years, we have gradually increased the fulfillment of certain of our best-selling products through our distribution center from approximately 25% to 39%.  With the opening of our larger Las Vegas distribution center in January 2006, which replaced our 6,000 square feet distribution center in Florida, we intend to continue to gradually increase the percentage of our orders fulfilled in-house. 

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**Marketing and Advertising**

          Our marketing andadvertising efforts have historically been almost entirely online initiatives,but we intend to aggressively pursue efficient methods of reaching additionalpotential customers through innovative offline advertising and marketinginitiatives. In addition, PoshTots has historically utilized a printed catalogas one of its marketing channels, a practice that we expect to continue. We havedeveloped a marketing strategy designed to increase brand recognition, generateconsumer traffic, acquire customers, build a loyal customer base and maximizerepeat purchases. Our primary target market is expectant parents, with womenrepresenting by far the largest segment of our customer base, and relatives andfriends who purchase baby, toddler and maternity products. Our marketinginitiatives primarily consist of the following: 

|   | *          Portal andTargeted Website Advertising.* A primary vehicle for our online advertisingis the optimized search results on websites with high traffic volumes. Wecurrently maintain advertising relationships or have preferred placementagreements with many search engines, including MSN, Overture, Google, andYahoo!, among others. Through these relationships, we advertise on websites thatappeal to our target customer base.                                                                                                                                                                                                                                                                                                                             |
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|   | *          Partnershipswith High Traffic Shopping Sites. *Due to our broad selection ofproduct offerings and our expanding presence through multiple websites, webelieve we are best able to support the baby product offerings of select hightraffic shopping websites like Buy.com and Amazon.com. In March 2006, we signedan agreement with Buy.com as a fulfillment provider of baby relatedproducts.  In December 2006, we reached an agreement with Amazon.com, Inc.to provide the rich content of our Internet sites, PoshCravings.com andePregnancy.com, to Amazon.com consumers through the Amazon Baby marketplace. Wewill also continue to pursue agreements with other female oriented content basedwebsites as their preferred e-commerce partner. |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   | *          E-mailMarketing.* We utilize an electronic direct marketing program to encouragerepeat purchases and customer retention, generate referral business and provideaccess to increasing numbers of prospective customers.  We recentlyimplemented additional e-mail list marketing initiatives, which have beendeveloped and used successfully by PoshTots.                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   | *          AffiliateProgram.* We also acquire customers by offering a web-marketing affiliateprogram that is intended to extend the reach of our brand and draw consumersfrom a variety of other websites. By joining our web-marketing affiliateprogram, operators of other websites earn commissions and enhance their websitesby providing their visitors access to our content and information as well as ourextensive selection of baby and toddler products.                                                                                                                                                                                                                                                                                                        |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   | *          PrintedCatalog. *PoshTots has historically utilized a printed catalog as oneof its marketing channels.  We expect to continue this practice forPoshTots.com and to evaluate including a printed catalog as a marketing channelfor our other websites.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |

          Once a customercompletes a purchase, we focus on establishing a continuing relationship withthat customer in order to encourage repeat purchases. To acquire new customers,we leverage our relationships with existing customers by encouraging them torefer friends and family. We also utilize permission-based email marketing tonon-buying visitors who indicate a desire to continue to be advised of ourofferings.

**Seasonality**

          We operate in theretail sales industry, which is seasonal and subject to general economicconditions, consumer spending and other factors. Our historical results ofoperations have been moderately seasonal, reflecting a general pattern of peaksales in mid-fourth quarter. Companies operating in the retail sales industrytypically realize a disproportionate amount of their net sales during the fourthquarter of each calendar year. If our business begins to more closely reflectindustry norms for seasonality, we may incur significant additional expensesduring our fourth quarter, including higher inventory of product and additionalstaffing in our fulfillment and customer support operations, in anticipation ofincreased sales activity. 

9

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**Competition**

          We operate in ahighly competitive environment. We principally compete with a variety of massmerchandisers, discount stores, department stores, Internet retailers, specialtyretailers and catalog merchandisers that offer products similar to or the sameas our products. Increased competition may result in price reductions, reducedgross margins and loss of market share, any of which could seriously harm ourfinancial condition and results of operations. We expect competition tointensify in the future because current and new competitors can enter our marketwith little difficulty and can launch new websites at a relatively low cost. Wecurrently or potentially compete with a variety of other companies that sellbaby, toddler and maternity products, including: 

|   | • | traditional store-based retailers, such as Babies R Us, Baby Gap andUSA Baby, and online efforts from these retailers such asBabiesRus.com; |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                  |
|   | • | other online retailers, such as Babycenter.com and Babyage.com;                                                                                       |
|   |   |                                                                                                                                                  |
|   | • | major discount retailers   such as Wal-Mart, Target and K-mart;                                                                                       |
|   |   |                                                                                                                                                  |
|   | • | catalog retailers;                                                                                                                                    |
|   |   |                                                                                                                                                  |
|   | • | vendors that currently sell some of their products directly online;                                                                                   |
|   |   |                                                                                                                                                  |
|   | • | other online retailers that include baby, toddler and maternity products as partof their product offerings, such as Amazon.com; and              |
|   |   |                                                                                                                                                  |
|   | • | Internet portals and online service providers that feature shopping services,such as AOL, Yahoo! and MSN.                                             |

          We believe that theprincipal competitive factors in our market are product selection and quality,price, customer service and support, brand recognition, reputation, reliabilityand trust, web site features and functionality, convenience and deliveryperformance. We believe that we compare favorably in the online market for brandname baby products by offering detailed product information, broad productselection, competitive pricing and knowledgeable customer support to ourcustomers. 

          Many of ourtraditional store-based and online competitors have longer operating histories,larger customer or user bases, greater brand recognition and significantlygreater resources, particularly financial and marketing resources. Many of thesecompetitors can devote substantially more resources to website development thanwe can. In addition, large, well-established and well-financed entities may joinwith online competitors in the future. Our competitors may be able to secureproducts from vendors on more favorable terms, offer popular products to whichwe do not have access, fulfill customer orders more efficiently and adopt moreaggressive pricing or inventory availability policies than we can. 

          The baby, toddlerand maternity product industries and the online commerce sector are highlycompetitive, dynamic in nature and have undergone significant changes over thepast several years and will likely continue to undergo significant changes. Ourability to anticipate and respond successfully to these changes is critical toour long-term growth and we cannot assure you that we will anticipate andrespond successfully to changes in the baby and toddler product industry andonline commerce sectors. If we are unable to maintain our market share orcompete effectively in the baby, toddler and maternity product market, ourbusiness, financial condition and operating results could be adversely affected.

**Information Technology and Systems**

          We have usedproprietary information technology systems for order fulfillment, merchandisingand our e-commerce platform since our inception. We are continually improvingthe overall technology infrastructure to improve the shopping experience, orderfulfillment capabilities and technical capacity.  We successfully completeda system conversion project during 2005 to replace our accounting and financialreporting system with software provided by a major software vendor, as well asseveral projects to improve the security and reliability of our networks. 

          During 2006, wecontinued our technology improvements with two additional importantprojects.  The first related to the implementation of a system to improveour warehouse management system, which coincided with the opening of our newdistribution center in Las Vegas in January 2006.  The second projectrelated to the replacement of our proprietary e-commerce platform through anoutsourcing contract with a major vendor.  The conversion to an entirelyoutsourced e-commerce platform will be completed in stages throughout2007.  

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          Our informationtechnology systems are currently, and will continue to be, hosted and backed upby third party providers. The facilities hosting our servers provide redundantheating, ventilation, air conditioning, power and Internet connectivity. Theback-up facilities are in place to protect our operations in the event ofhardware failure or facility failure and/or regional Internet or communicationsfailures. In the event that our service providers experience a disruption inoperations or cease operations for any reason, we will switch to back-up hostingfacilities.

          Our ability toreceive and fulfill orders successfully through our websites is critical to oursuccess and largely depends upon the efficient and uninterrupted operation ofour computer and communications hardware and software systems, including thesuccessful conversion of those systems that are undergoing replacement orupgrade. Our systems and operations are vulnerable to unanticipated difficultiesencountered during system conversion, upgrade or replacement, as well as todamage or interruption from power outages, computer and telecommunicationsfailures, computer viruses, security breaches, terrorist attacks, naturaldisasters and other catastrophic events, and errors in usage by our employeesand customers. Any significant interruption in the availability or functionalityof our websites, or our order processing, fulfillment, distribution orcommunications systems, for any reason could seriously harm our business.

**Intellectual Property**

          We believe that ourregistered trademarks, “BabyUniverse.com”,“DreamtimeBaby.com”, “PoshTots.com”“PoshLiving.com”, “PoshCravings.com”,“ePregnancy.com” and “BabyTV.com”, and the brand namerecognition that we have developed are of significant value. We strive topreserve the quality of our brand names and protect our trademarks and otherintellectual property rights to ensure that the value of our proprietary rightsis maintained. We rely on various intellectual property laws and contractualrestrictions to protect our proprietary rights. These include copyright andtrade secret laws and confidentiality, invention assignment and nondisclosureagreements with our employees, contractors, suppliers and strategic partners.Despite these precautions, it may be possible for a third party to copy orotherwise obtain and use our intellectual property without our authorization. Inaddition, we pursue the registration of our trademarks and service marks in theU.S. and internationally. However, effective intellectual property protectionmay not be available in every country in which our products and services aremade or will be made available online. For example, a company named BabyUniverse based in New Zealand that uses the domain name*babyuniverse.co.nz* sells baby products via the Internet. If we are unableto protect or preserve the value of our intellectual property for any reason,our business would be harmed.

          We also rely ontechnologies and products that we license from third parties. These licenses maynot continue to be available to us on commercially reasonable terms, or at all,in the future. As a result, we may be required to develop or obtain substitutetechnology and products of lower quality and/or at greater cost, which couldmaterially adversely affect our business, operating results and financialcondition. Further, third parties may claim infringement by us with respect toour use of current or future technologies, whether developed by us or licensedfrom other parties. In addition, third parties may claim that the sale of one ormore of our product offerings infringes their intellectual property rights. Weexpect that participants in our markets will be increasingly subject toinfringement claims as the number of services and competitors in our industrysegment grows. Any such claim, with or without merit, could be time consuming,result in costly litigation, cause service upgrade delays, cause us todiscontinue use of a particular technology or the availability of a particularproduct offering, or require us to pay monetary damages or enter into royalty orlicensing agreements. Such royalty or licensing agreements might not beavailable on terms acceptable to us or at all. As a result, any such claim ofinfringement against us could have a material adverse effect upon our business,operating results and financial condition. 

**Government Regulation**

          We are not currentlysubject to direct federal, state or local regulation other than regulationsapplicable to businesses generally or directly applicable to retailing or onlinecommerce. However, as the Internet becomes increasingly popular, it is possiblethat a number of laws and regulations may be adopted with respect to theInternet. These laws may cover issues such as user privacy, freedom ofexpression, pricing, content and quality of products and services, taxation,advertising, intellectual property rights and information security. Further, thegrowth of online commerce may prompt calls for more stringent consumerprotection laws. Several states have proposed legislation to limit the uses ofpersonal user information gathered online or require online companies toestablish privacy policies. The Federal Trade Commission has also initiatedaction against at least one online company regarding the manner in whichpersonal information is collected from users and provided to third parties. Theadoption of additional privacy or consumer protection laws could createuncertainty in Internet usage and reduce the demand for our products andservices. 

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          We are not certainhow our business may be affected by the application of existing laws governingissues such as property ownership, copyrights, encryption and other intellectualproperty issues, taxation, libel, obscenity, qualification to do business andexport or import matters. The vast majority of these laws were adopted prior tothe advent of the Internet. As a result, they do not contemplate or address theunique issues of the Internet and related technologies. Changes in laws intendedto address these issues could create uncertainty for those conducting onlinecommerce. This uncertainty could reduce demand for our products and services orincrease the cost of doing business as a result of litigation costs or increasedfulfillment costs. 

          In addition, becauseour products and services are available over the Internet in multiple states,certain states may claim that we are required to qualify to do business in suchstate. Currently, we are qualified to do business in the states ofFlorida,  Nevada and Virginia. Our failure to qualify to do business in ajurisdiction where we are required to do so could subject us to taxes andpenalties. It could also hamper our ability to enforce contracts in thesejurisdictions. The application of laws or regulations from jurisdictions whoselaws do not currently apply to our business could harm our business and resultsof operations. 

**Employees**

          As of March 14,2007, we had 87 full time employees, including 32 employees related to thePoshTots business acquired on January 13, 2006. Our employees are not party toany collective bargaining agreement, and we have never experienced an organizedwork stoppage. We believe our relations with our employees are good. 

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| **ITEM 1A.** | **RISK   FACTORS** |
|--------------|--------------------|

**Risks Related to Our Business**

**Our limited operating history makes it difficult for us to accuratelyforecast our revenues and appropriately plan our expenses.**

          We commencedoperations in 1997 and have a limited operating history. As a result, it isdifficult to accurately forecast our revenue and plan our operating expenses. Webase our current and future expense levels on our operating forecasts andestimates of future revenues. Revenues and operating results are difficult toforecast because they generally depend on the volume and timing of the orders wereceive, which are uncertain. Some of our expenses are fixed and, as a result,we may be unable to adjust our spending in a timely manner to compensate for anyunexpected shortfall in revenues. This inability could cause our net income in agiven quarter to be lower, or our net loss in a given quarter to be higher, thanexpected. 

**We have incurred significant operating losses in the past and may not be ableto sustain profitability in the future.**

          We experiencedsignificant operating losses from our commencement of operations and were notprofitable on a full year basis except for 2004. As a result, our business has alimited record of profitability and may not become profitable or increase inprofitability. If we are unable to acquire baby, toddler and maternity productsat commercially reasonable prices, if revenues decline or if our expensesotherwise exceed our expectations, we may not be able to sustain or increaseprofitability on a quarterly or annual basis. 

          As a result of oursignificant operating losses in prior periods, we have accrued substantial netoperating loss carryforwards. If we are unsuccessful in generating sufficientnet income in future periods, these assets may expire before they are utilized.

**We have significant working capital needs and if we are unable to obtainadditional financing, when needed, we may not have sufficient cash flow to runour business.**

          As of December 31,2006, our cash on hand amounted to just over $3.47 million.  While weintend to finance our future operations from our cash balance and from cash flowfrom operations, these sources may not provide us with adequate financing. In that event, we would need to seek additional financing from lenders andinvestors.  If we are not able to obtain such adequate financing, whenneeded, it would have a material adverse effect on our financial condition andresults of operations. 

**The terms of our indebtedness mayrestrict our ability to operate and grow our business.**

          The terms of ourSenior Loan and Security Agreement with Hercules Technology Capital, Inc. (the“Loan” or the “Loan Agreement”) impose restrictions on ourability to, among other things, borrow and make investments, acquire otherbusinesses, and make capital expenditures and distributions on our capitalstock.  In addition, the Loan Agreement requires us to satisfy specifiedfinancial covenants, including a covenant to maintain a current ratio of atleast .90 on December 31, 2006 and at least 1.0 thereafter.  Our ability tocomply with these provisions depends, in part, on factors over which we may nothave control.  These restrictions could adversely affect our ability topursue our operating and growth strategy.  If we fail to maintain therequired current ratio, we have certain rights to cure such failure with anequity financing, but there can be no assurance that we would be able to raisesuch equity financing to effectuate such a cure.  If we were to breach anyof our financial covenants with our creditors or fail to make scheduledpayments, and such breach continues beyond applicable cure periods, suchcreditors could declare all amounts owed to them to be immediately due andpayable.  We may not have available funds sufficient to repay the amountsdeclared due and payable and may have to sell our assets to repay those amounts.The Loan is secured by substantially all of our assets. If we cannot repay allamounts that we have borrowed under the Loan Agreement, the lender thereundercould proceed against our assets.

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**Our quarterly operating results may fluctuate and could be below expectationsbecause we operate in the retail sales industry, which isseasonal.**

          We operate in theretail sales industry, which is seasonal and dependent on general economicconditions, consumer spending and other factors. Our historical results ofoperations have been moderately seasonal, reflecting a general pattern of peaksales in mid-fourth quarter. We believe that our limited operating history andhistorical growth trends may have masked the effect of typical seasonalfluctuations. We cannot assure you that our business will continue itshistorical growth trend, or that it will not conform to industry norms forseasonality in future periods. Companies operating in the retail sales industrytypically realize a disproportionate amount of their revenues during the fourthquarter of each calendar year. If our business begins to reflect industry normsfor seasonality, we may incur significant additional expenses during our fourthquarter, including higher inventory of product and additional staffing in ourfulfillment and customer support operations, in anticipation of increased salesactivity. Consequently, if we were to experience lower than expected revenuesduring any future fourth quarter, whether from a general decline in economicconditions or other factors beyond our control, it would have adisproportionately large impact on our operating results and financial conditionfor that year. In the future, our seasonal sales patterns may become morepronounced, may strain our personnel and fulfillment activities and may cause ashortfall in revenues as compared to expenses in a given period, which wouldsubstantially harm our financial condition and results of operations.

**Purchasers of baby, toddler and maternity products may not choose to shoponline, which would prevent us from increasing revenues.**

          The online marketfor baby, toddler and maternity products is significantly less developed thanthe online market for books, music and other consumer products. If this marketdoes not gain widespread acceptance, our business may suffer. Our success willdepend in part on our ability to attract consumers who have historicallypurchased baby, toddler and maternity products through traditional retailers.Furthermore, we may have to incur significantly higher and more sustainedadvertising and promotional expenditures or price our products morecompetitively than we currently anticipate, in order to attract additionalonline consumers to our websites and convert them into purchasing customers.Specific factors that could dissuade consumers from purchasing baby, toddler andmaternity products from us include:  

|   | • | concerns about buying baby, toddler and maternity products such as luxurystrollers, expensive car seats and bedding for their child without a physicalstorefront, face-to-face interaction with sales personnel and the ability tophysically handle and examine products; |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                      |
|   | • | delivery time and/or costs   associated with Internet orders;                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                      |
|   | • | product offerings that do not reflect consumer tastes andpreferences;                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                      |
|   | • | pricing that does not meet   consumer expectations;                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                      |
|   | • | concerns about the security of online transactions and the privacy of personalinformation;                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                      |
|   | • | delayed shipments or shipments of incorrect or damaged products; and                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                      |
|   | • | inconvenience associated with returning or exchanging purchaseditems.                                                                                                                                                                                                     |

**We intend to undertake acquisitions to expand our business, which may poserisks to our business and dilute the ownership of our existingshareholders.**

          A key component ofour business strategy includes strengthening our competitive position andrefining the customer experience on our websites through internal developmentand growth. However, we intend to selectively pursue strategic acquisitions ofcompanies in our industry. Integrating any newly acquired companies may beexpensive and time-consuming. To finance any acquisition, it may be necessaryfor us to raise additional funds through public or privatefinancings.

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Additional funds may not be available on terms that are favorable to us, and, inthe case of equity financings, would result in dilution to our shareholders. Anysuch acquisition may involve a number of risks, including: 

|   | • | Financial risks, such as (1) potential liabilities of the acquired company;(2)  costs associated with integrating acquired operations and businesses;(3)  the dilutive effect of the issuance of additional equity securities;(4)  the incurrence of debt; (5)  the financial impact of valuinggoodwill and other intangible assets involved in any acquisitions, potentialfuture impairment write-downs of goodwill and the amortization of otherintangible assets; (6)  possible adverse tax and accounting effects; and(7)  overpayment for the company. |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|   | • | Operating risks, such as (1)  the diversion of management’s attentionto the integration of the businesses to be acquired; (2)  the risk that theacquired businesses will fail to maintain the quality of services that we havehistorically provided; (3)  the need to implement financial and othersystems and add management resources; (4) the risk that key employees of theacquired businesses will leave after the acquisition; and (5)  unforeseendifficulties in the acquired operations.                                                                 |

          We cannot assure youthat we will be able to consummate any acquisitions or, if consummated,successfully integrate the operations and management of future acquisitions. Ifwe are unable to attract and consummate acquisitions, our growth could beadversely impacted. 

**We may not succeed in continuing to establish our brands, which would preventus from acquiring customers and increasing our revenues.**

          Since we have alimited operating history, a significant component of our business strategy isthe continued establishment and promotion of the BabyUniverse, DreamtimeBaby,PoshTots, PoshLiving, PoshCravings ePregnancy and BabyTV brands. Due to thehighly-fragmented and competitive nature of the online market for baby, toddlerand maternity products, if we do not continue to establish our brands, we mayfail to build the critical mass of customers required to substantially increaseour revenues. Promoting and positioning our brands will depend largely on thesuccess of our marketing and merchandising efforts and our ability to provideconsistent, high quality customer experiences. To promote our brands, we haveincurred and will continue to incur substantial expenses related to advertising,public relations and other marketing efforts. The failure of our brand promotionactivities could adversely affect our ability to attract new customers andmaintain customer relationships, and, as a result, substantially harm ourfinancial condition and results of operations. 

**We face significant competition and may be unsuccessful in competing againstcurrent and future competitors.**

          The baby, toddlerand maternity products retail industry is intensely competitive, and we expectcompetition in the market to increase and intensify in the future. Increasedcompetition may result in price pressure, reduced gross margins and loss ofmarket share, any of which could substantially harm our financial condition andresults of operations. Current and potential competitors include: 

|   | • | traditional store-based retailers, such as Babies R Us, Baby Gap andUSA Baby, and online efforts from these retailers such asBabiesRus.com; |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                  |
|   | • | other online retailers,   such as Babycenter.com and Babyage.com;                                                                                     |
|   |   |                                                                                                                                                  |
|   | • | major discount retailers   such as Wal-Mart, Target and K-mart;                                                                                       |
|   |   |                                                                                                                                                  |
|   | • | catalog retailers;                                                                                                                                    |
|   |   |                                                                                                                                                  |
|   | • | vendors that currently sell some of their products directly online;                                                                                   |
|   |   |                                                                                                                                                  |
|   | • | other online retailers that include baby, toddler and maternity products as partof their product offerings, such as Amazon.com; and              |
|   |   |                                                                                                                                                  |
|   | • | Internet portals and online service providers that feature shopping services,such as AOL, Yahoo! and MSN.                                             |

          Many of our currentand potential competitors have advantages over us, including longer operatinghistories, greater brand recognition, more extensive customer and supplierrelationships, and significantly greater financial, marketing and otherresources. In addition, traditional store-based retailers offer consumers theability to physically handle and examine products in a manner that is notpossible over the Internet, as well as a more convenient means of returning andexchanging purchased products. 

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          Some of ourcompetitors seeking to establish an online presence may be able to devotesubstantially more resources to website systems development and exert moreleverage over the supply chain for baby, toddler and maternity products than wecan. In addition, larger, more established and better capitalized entities mayacquire, invest in or partner with traditional and online competitors as use ofthe Internet and other online services increases. Our online competitors canduplicate many of the products, services and content we offer, which could harmour financial condition and results of operations. 

**In order to increase revenues and to sustain or increase profitability, wemust attract customers in a cost-effective manner.**

          Our success dependson our ability to attract customers in a cost-effective manner. We haverelationships with providers of online services, search engines, directories andother websites and e-commerce businesses to provide content, advertising bannersand other links that direct customers to our websites. We rely on theserelationships as significant sources of traffic to our websites. Our agreementswith these providers generally have terms of one year or less. If we are unableto develop or maintain these relationships on acceptable terms, our ability toattract new customers would be harmed. In addition, many of the parties withwhich we have online-advertising arrangements could provide advertising servicesto other online or traditional retailers, including retailers with whom wecompete. As a result, these parties may be reluctant to enter into or maintainrelationships with us. Without these relationships, traffic to our websitescould be reduced, which would substantially harm our financial condition andresults of operations.  

**The shopping comparison portals on which we list our products (and throughwhich we currently generate a significant percentage of our customer orders) mayalter the terms of their merchant agreements at will, exposing us to a number ofrisks, including higher fees and an increased challenge of gaining prominentplacement of our products on these portals.**

          By virtue of thelisting of our products on the various shopping comparison portals through whichwe currently generate a significant percentage of our customer orders, we aresubject to the terms and conditions of such portals’ merchant and similaragreements. These agreements differ from one shopping comparison portal toanother, but, in general, they provide that the comparison shopping portals canfreely alter the terms and conditions of such agreements.  

          This exposes us to anumber of potential risks, including the risk that any or all of these portalsmay: 

|   | • | implement policies that prohibit our multiple website marketingstrategy;                                                                                                                                                              |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                  |
|   | • | given their relative bargaining power as compared to listing merchants such asus, raise the minimum fees that some of these portalsimpose; and                                                                                   |
|   |   |                                                                                                                                                                                                                                  |
|   | • | alter the bases for a merchant’s initial or default listing on certain ofthese portals, which currently are dependent on such variables as the productprice points or the quality of the merchant’s customer reviewratings. |

          Changes in the termsand conditions of our merchant and similar agreements with the shoppingcomparison portals on which we list our products could change or limit ourmarketing strategies, which may, in turn, disadvantage us relative to ourcompetitors, particularly those with greater financial resources, increase ouroperating expenses and otherwise harm our business. 

**Our failure to meet customer expectations with respect to price wouldadversely affect our financial condition and results ofoperations.**

          Demand forour products has been highly sensitive to pricing changes. In fact, we believethat a significant percentage of our online shoppers are greatly motivated byprice. While we maintain manufacturer’s suggested retail pricing for somepopular products, certain of our competitors may discount products below theselevels. We may, therefore, be forced to lower prices for certain products. Anysuch changes in our pricing strategies have had and may continue to have asignificant impact on our revenues, gross margins and net income or net loss. If we fail tomeet customer expectations with respect to price in any given period, ourrevenues may be negatively impacted and our financial condition and results ofoperations would suffer.

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**We rely primarily on the sale of baby, toddler and maternity products for ourrevenues, and demand for these products could decline.**

          The volume anddollar value of purchases of baby, toddler and maternity products, such asstrollers, car seats and bedding, may significantly decrease during economicdownturns. The success of our business depends in part on macroeconomic factorssuch as employment levels, salary levels, tax rates and credit availability, allof which affect consumer spending and disposable income. Any reduction inconsumer spending or disposable income may affect us more significantly thancompanies in other industries. 

          Our revenues andresults of operations are, in part, dependent on the demand for strollers, carseats and bedding. Should prevailing consumer tastes for these products decline,demand for our products would decline and our business and results of operationswould be substantially harmed. 

**Our brands and reputation and our ability to increase revenues may depend onour ability to successfully expand our product offerings.**

          Our ability tosignificantly increase our revenues and maintain and increase our profitabilitymay depend on our ability to successfully expand our product lines and ourtargeted product end user age group beyond our current offerings. Specifically,we intend to expand our product offerings in the toddler and maternity markets.If we offer a new product category that is not accepted by consumers or if weoffer a series of products that are recalled for safety reasons, our brands andreputation could be adversely affected, our revenues may fall short ofexpectations and we may incur substantial expenses that are not offset byincreased revenues. Expansion of our product lines may also strain ourmanagement and operational resources.  

**If we decide to offer new product lines or categories, we may jeopardize ourcurrent reputation and experience a decline in our operatingresults.**

          We currentlygenerate substantially all of our revenue from the sale of baby products. If wedecide to commence offering new product lines or categories, our internal salesand delivery processes may not prove effective with respect to such otherproduct categories. In addition, expansion into new product lines or categoriesmay require us to incur significant marketing expenses and capital investments,develop sourcing arrangements with new vendors and comply with additionalregulatory requirements. These requirements could strain our managerial,financial and operational resources. Additional challenges that may affect ourability to expand into new product categories include our ability to:

|   | • | attract and retain suppliers to provide the expanded line of products to ourcustomers on terms that are acceptable to us; |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                      |
|   | • | establish or increase awareness of new brands and product categories;                                                     |
|   |   |                                                                                                                      |
|   | • | successfully market these new product offerings to existing and newcustomers;                                             |
|   |   |                                                                                                                      |
|   | • | achieve and maintain a critical mass of customers and orders across theseproduct categories; and                     |
|   |   |                                                                                                                      |
|   | • | maintain quality control over merchandise drop shipped directly by our suppliersto our customers.                         |

          We may not be ableto successfully address any or all of these challenges. This could hamper acomponent of our growth strategy, damage our reputation in the eyes of ourexisting customers or suppliers, and cause a decline in our results ofoperations. 

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**If our fulfillment operations are interrupted for any significant period oftime, our reputation and brand could be damaged and our financial condition andresults of operations would be substantially harmed.**

          Our success dependson our ability to successfully receive and fulfill orders and to promptly andsecurely deliver our products to our customers. A portion of our inventorymanagement, packaging, labeling and product return processes are performed frommultiple facilities operated by other companies. Our newly opened Las Vegasfulfillment center is susceptible to damage or interruption from human error,fire, flood, power loss, telecommunications failure, terrorist attacks, acts ofwar, break-ins, earthquakes and similar events. We do not currently maintainback-up power systems at our Las Vegas fulfillment center. Our insurance may beinsufficient to compensate us for losses that may occur in the event operationsat our fulfillment center or a fulfillment center of one of our fulfillmentvendors is interrupted. We may transfer or expand our fulfillment operations toa larger fulfillment center, or multiple fulfillment centers, in the future. Anyinterruptions in our fulfillment center operations for any significant period oftime, including interruptions resulting from the transfer to a new facility orthe conversion to newly developed warehouse management systems, could damage ourreputation and brand and substantially harm our financial condition and resultsof operations. 

**Our failure to acquire inventory at commercially reasonable prices wouldresult in higher costs and lower gross margins and damage our competitiveposition.**

          We purchase productsfor resale either directly from manufacturers, via drop ship arrangements orthrough our newly opened Las Vegas distribution center, or, to a lesser degree,through our California fulfillment agent. If we are unable to acquire inventoryat commercially reasonable prices, our costs may exceed our forecasts, our grossmargins and operating results may suffer and our competitive position could bedamaged. The success of our business model depends, in part, on our ability tooffer prices to customers that are at or below those of traditional babyretailers. We do not have supply agreements with our suppliers or suchagreements are cancelable upon 30 -days notice, and therefore, they canstop supplying us products at any time, for no reason and with limited or nonotice. Our inability to maintain and expand these and other inventory supplyrelationships on commercially reasonable terms or the inability of our currentand future suppliers to maintain arrangements for the supply of products sold tous on commercially reasonable terms would substantially harm our financialcondition and results of operations. 

**If we fail to successfully expand our fulfillment capabilities, we may not beable to increase our revenues.**

          We fulfillapproximately 39% of our orders through our leased Las Vegas fulfillment centerand a third party warehouse and fulfillment center in St. Louis. We thereforerely extensively on other companies to fulfill our orders. If we or our vendorsfail to quickly and efficiently fill customer orders, our operating results maysuffer. The increased demand and other considerations may require us tosignificantly expand our fulfillment capabilities and facilities in the future.If we or our vendors do not successfully expand our or their fulfillmentcapabilities to accommodate increases in demand, we may not be able tosubstantially increase our revenues. Our efforts at expanding our fulfillmentcapabilities may cause disruptions in other areas of our business which couldsubstantially harm our business and results of operations. 

**We rely on our suppliers and third-party carriers as a large part of ourfulfillment process, and these third parties may fail to adequately serve ourcustomers.**

          In general, weextensively rely on our suppliers to promptly ship products to us or directly toour customers. Any failure by our suppliers to sell and ship such products to usor our customers will have an adverse effect on our ability to fulfill customerorders and harm our business and results of operations. Our suppliers, in turn,rely on third-party shippers to ship products to us or directly to thecustomers. We also rely on third-party shippers for product shipments to ourcustomers. We are therefore subject to the risks, including employee strikes andinclement weather, associated with such carriers’ abilities to providedelivery services to meet our and our suppliers’ shipping needs. Oursuppliers’ and third-party carriers’ failure to deliver products to usor our customers in a timely manner or to otherwise adequately serve ourcustomers would damage our reputation and brand and substantially harm ourfinancial condition and results of operations. 

18

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**If we are unable to accurately manage our inventory, our costs of goods soldmay increase more than expected and our reputation, financial condition andresults of operations could suffer.**

          While we havehistorically maintained low levels of inventory, we have recently begun toincrease the levels of inventory we carry. Therefore, changes in consumer tastesfor our products will subject us to increased inventory risks. The demand forspecific products can change between the time we order an item and the date wereceive it. Also, if we, our drop shippers or our fulfillment partnerunder-stock one or more of our products, we may not be able to obtain additionalunits in a timely manner on terms favorable to us, if at all, which would damageour reputation and substantially harm our business and results of operations. Inaddition, if demand for our products increases over time, we may be forced toincrease inventory levels. If one or more of our products does not achievewidespread consumer acceptance, we may be required to take significant inventorymarkdowns, or may not be able to sell the product at all, which wouldsubstantially harm our financial condition and results of operations.

**Our failure to effectively manage the growth in our operations may prevent usfrom successfully expanding our business.**

          We have experienced,and in the future may experience, rapid growth in operations, which has placed,and could continue to place, a significant strain on our operations, services,internal controls and other managerial, operational and financial resources. Toeffectively manage future expansion, we will need to maintain and/or expand ouroperational and financial systems and managerial controls and procedures, whichinclude the following processes: 

|   | • | transaction-processing and   fulfillment;                         |
|--------|--------|-------------------------------------------------------------------|
|   |   |                                                              |
|   | • | inventory management;                                             |
|   |   |                                                              |
|   | • | customer support;                                                 |
|   |   |                                                              |
|   | • | management of multiple   supplier relationships;                  |
|   |   |                                                              |
|   | • | operational, financial and   managerial controls;                 |
|   |   |                                                              |
|   | • | reporting   procedures; and                                  |
|   |   |                                                              |
|   | • | training, supervision, retention and management of our employees. |

          If we are unable tomanage future expansion, our ability to provide a high quality customerexperience could be harmed, which would damage our reputation and brand andsubstantially harm our financial condition and results of operations.

**Any significant interruption in the availability or functionality of ourwebsites, or our order processing, fulfillment, distribution or communicationssystems, for any reason could seriously harm our business.**

          We have usedproprietary information technology systems for order fulfillment, merchandisingand our e-commerce platform since our inception. We are continually improvingthe overall technology infrastructure to improve the shopping experience, orderfulfillment capabilities and technical capacity.  In that regard, wesuccessfully completed a system conversion project during 2005 to replace ouraccounting and financial reporting system with software provided by a majorsoftware vendor, as well as several projects to improve the security andreliability of our networks.  

          During 2006, wecontinued our technology improvements with two additional importantprojects.  The first related to the implementation of a system to improveour warehouse management system, which coincided with the opening of our newdistribution center in Las Vegas in January 2006.  The second projectrelated to the replacement of our proprietary e-commerce platform through anoutsourcing contract with a major vendor.  The conversion to an entirelyoutsourced e-commerce platform will be completed in stages throughout2007.  

19

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          Our ability toreceive and fulfill orders successfully through our websites is critical to oursuccess and largely depends upon the efficient and uninterrupted operation ofour computer and communications hardware and software systems, including thesuccessful conversion of those systems that are undergoing replacement orupgrade. Our systems and operations are vulnerable to unanticipated difficultiesencountered during system conversion, upgrade or replacement, as well as todamage or interruption from power outages, computer and telecommunicationsfailures, computer viruses, security breaches, terrorist attacks, naturaldisasters and other catastrophic events, and errors in usage by our employeesand customers. Any significant interruption in the availability or functionalityof our websites, or our order processing, fulfillment, distribution orcommunications systems, for any reason could seriously harm our business.

**If the hosting facilities where substantially all of our computer andcommunications hardware is located fail, our ability to effectively conductbusiness would be harmed.**

          Our ability tosuccessfully receive and fulfill orders and to provide high quality customerservice depends in part on the efficient and uninterrupted operation of ourcomputer and communications systems. Our systems and operations are vulnerableto damage or interruption from human error, fire, flood, power loss,telecommunications failure, terrorist attacks, acts of war, break-ins andsimilar events. We do not presently have entirely redundant systems in multiplelocations and our business interruption insurance may be insufficient tocompensate us for losses that may occur. In addition, our servers are vulnerableto computer viruses, physical or electronic break-ins and similar disruptions,which could lead to interruptions, delays, loss of critical data, the inabilityto accept and fulfill customer orders or the unauthorized disclosure ofconfidential customer data. The occurrence of any of the foregoing risks couldsubstantially harm our financial condition and results of operations.

**We rely on the services of our key personnel, any of whom would be difficultto replace.**

          We rely upon thecontinued service and performance of key technical, fulfillment and seniormanagement personnel. If we lose any of these personnel, our business couldsuffer. Our future success depends on our retention of key employees,including  John C. Textor, our Chairman of the Board and Chief ExecutiveOfficer, and Jonathan Teaford, Executive Vice President, both of whom we rely onfor management of our company, development of our business strategy andmanagement of our strategic relationships. Executive officers of the Company arebound by employment and noncompetition agreements. However, many of our otherkey technical, fulfillment or management personnel are not bound by employmentor noncompetition agreements, and, as a result, these employees could leave withlittle or no prior notice. 

**Failure to adequately protect our intellectual property could damage ourreputation and brands and substantially harm our business, financial conditionand results of operations.**

          Our successdepends to a significant extent upon the protection of our proprietaryintellectual property rights. We rely on a combination of trademarks, tradesecrets, copyright law and contractual restrictions to protect our intellectualproperty. These afford only limited protection. Despite our efforts to protectand enforce our proprietary rights, unauthorized parties may attempt to copyaspects of our website features and functionality or to obtain and useinformation that we consider as proprietary, such as the technology used tooperate our websites, our content and our trademarks. 

          We have registered“BabyUniverse.com”, “DreamtimeBaby.com”,“PoshTots.com”, “PoshLiving.com”,“PoshCravings.com”, “ePregnancy.com” and“BabyTV.com”, and the related logos as trademarks in the U.S. andCanada. We have also applied for the registration of our logos in their currentformats in the United States and expect to continue to pursue the registrationof our key service marks in relevant jurisdictions from time to time. There canbe no assurance that any of these applications will be approved, that any issuedregistration will protect our intellectual property or that third parties willnot challenge our marks. In addition, it is possible that trademark protectionmay not be available or may not be sought in every country in which our servicesare made available online. 

          Our competitorshave, and other competitors may, adopt service names similar to ours, therebyimpeding our ability to build brand identity and possibly leading to customerconfusion. In addition, there could be potential infringement claims brought byowners of other registered trademarks that incorporate variations of ourtrademarks or servicemarks. Any claims or customer confusion related to ourtrademarks or service marks could damage our reputation and brands andsubstantially harm our business, financial condition and results of operations.

20

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          We currently holdseveral Internet domain names. Domain names generally are regulated by Internetregulatory bodies. We have not registered any country-specific domain names. Ifwe lose the ability to use a domain name in a particular country, we would beforced to either incur significant additional expenses to market our productswithin that country, including the development of a new brand and the creationof new promotional materials and packaging, or elect not to sell products inthat country. Either result could substantially harm our business and results ofoperations. The regulation of domain names in the United States and in foreigncountries is subject to change. Regulatory bodies could establish additionaltop-level domains, appoint additional domain name registrars or modify therequirements for holding domain names. As a result, we may not be able toacquire or maintain relevant domain names in all of the countries in which wecurrently or intend to conduct business. 

          The domain name*babyuniverse.co.nz* is registered and owned by a company named BabyUniverse based in New Zealand. We are not related to or affiliated with the NewZealand company. The New Zealand company sells baby products via the Internetand appears to be focused substantially on the markets of Australia and NewZealand, as it claims on its website that many of its overseas customers placeorders for friends and relatives living in Australia and New Zealand. The NewZealand company also claims it can ship to and has customers located in theUnited States, Canada and other countries where we conduct or intend to conductbusiness in the future. We have advised the New Zealand website to cease anddesist from shipping goods into the United States. Our inability to successfullyassert the priority of our rights in the BabyUniverse or our other names,trademarks and brands in the United States or other countries could harm ourbusiness and results of operations. 

          Litigation orproceedings before the U.S. Patent and Trademark Office may be necessary inthe future to enforce our intellectual property rights, to protect our tradesecrets and domain names and to determine the validity and scope of theproprietary rights of others. Any litigation or adverse priority proceedingcould result in substantial costs and diversion of resources and couldsubstantially harm our business and results of operations. Finally, we intend tosell our products internationally, and the laws of many countries do not protectour proprietary rights to as great an extent as do the laws of the UnitedStates. 

**Assertions by third parties of infringement by us of their intellectualproperty rights could result in significant costs and substantially harm ourbusiness and results of operations.**

          Other parties mayassert infringement or unfair competition claims against us. In the past, wehave received notices from third parties alleging that our service marksinfringe proprietary rights held by them. We may receive other similar noticesfrom, or have lawsuits filed against us by, third parties in the future. Wecannot predict whether third parties will assert claims of infringement againstus, or whether any past, present or future claims will prevent us from operatingour business as planned or whether any such assertions or claims arising fromsuch assertions will substantially harm our business and results of operations.If we are forced to defend against any infringement claims, whether they arewith or without merit or are determined in our favor, we may face costlylitigation, diversion of technical and management personnel or product shipmentdelays. Furthermore, the outcome of a dispute may be that we would need todevelop non-infringing technology or enter into royalty or licensing agreements.Royalty or licensing agreements, if required, may not be available on termsacceptable to us, or at all. 

**Increased product returns and the failure to accurately predict productreturns could substantially harm our business and results ofoperations.**

          We offer ourcustomers 30 day return policies that allow our customers to return mostproducts (except special order items that are subject to a 30% restocking fee)if they are not satisfied with their purchase for any reason. Actual merchandisereturns are difficult to predict and may significantly exceed our projections orour expectations. Any significant increase in merchandise returns above ourallowances would substantially harm our business, financial condition andresults of operations.  

21

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**We may be unsuccessful in expanding our operations internationally.**

          To date, we havemade very limited international sales, but we anticipate expanding ourinternational sales in the long term. Any international expansion plans wechoose to undertake will require management attention and resources and may beunsuccessful. We have minimal experience in selling our products ininternational markets or in conforming to the local cultures, standards orpolicies necessary to successfully compete in those markets. We do not currentlyhave any international fulfillment, distribution or server facilities or anywebsite content localized for foreign markets and we cannot be certain that wewill be able to establish a global presence if we choose to expandinternationally. In addition, we may have to compete with retailers that havemore experience with local markets. Our ability to expand internationally mayalso be limited by the demand for our products and the adoption of e-commerce inthese markets. Different privacy, censorship and liability standards andregulations and different intellectual property laws in foreign countries maycause our financial condition and results of operations to suffer. 

          Any futureinternational operations may also fail to succeed due to other risks inherent inforeign operations, including:

|   | • | the need to develop new   supplier and shipper relationships;                                  |
|--------|--------|------------------------------------------------------------------------------------------------|
|   |   |                                                                                           |
|   | • | unexpected changes in international regulatory requirements andtariffs;                        |
|   |   |                                                                                           |
|   | • | higher costs, and longer delivery times, associated with internationalshipping;                |
|   |   |                                                                                           |
|   | • | difficulties in staffing   and managing foreign operations;                                    |
|   |   |                                                                                           |
|   | • | longer payment cycles from   credit card companies;                                            |
|   |   |                                                                                           |
|   | • | potential adverse tax   consequences;                                                          |
|   |   |                                                                                           |
|   | • | lack of infrastructure to adequately conduct e-commerce transactions orfulfillment operations; |
|   |   |                                                                                           |
|   | • | the inability to use our   various brand names or trademarks;                                  |
|   |   |                                                                                           |
|   | • | price controls or other restrictions on or fluctuations in foreigncurrency; and           |
|   |   |                                                                                           |
|   | • | difficulties in obtaining export and import licenses.                                          |

          Our failure tosuccessfully expand our operations internationally may cause our financialcondition and results of operations to suffer. 

**Risks Related to Our Industry**

**If use of the Internet, particularly with respect to online commerce, doesnot continue to increase as rapidly as we anticipate, our business will beharmed.**

          Our future revenuesand profits are substantially dependent upon the continued use of the Internetas an effective medium of business and communication by our target customers.Internet use may not continue to develop at historical rates and consumers maynot continue to use the Internet and other online services as a medium forcommerce. Highly publicized failures by some online retailers to meet consumerdemands could result in consumer reluctance to adopt the Internet as a means forcommerce, and thereby damage our reputation and brand and substantially harm ourfinancial condition and results of operations. 

          In addition, theInternet may not be accepted as a viable long-term commercial marketplace for anumber of reasons, including: 

|   | • | the need to develop new supplier and shipper relationships;                                                         |
|--------|--------|---------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                |
|   | • | actual or perceived lack of security of information or privacyprotection;                                           |
|   |   |                                                                                                                |
|   | • | possible disruptions, computer viruses or other damage to the Internet serversor to users’ computers; and |

22

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|   | • | excessive governmental   regulation. |
|--------|--------|--------------------------------------|

          Our success willdepend, in large part, upon third parties maintaining the Internetinfrastructure to provide a reliable network backbone with the speed, datacapacity, security and hardware necessary for reliable Internet access andservices. Our business, which relies on contextually rich websites that requirethe transmission of substantial data, is also significantly dependent upon theavailability and adoption of broadband Internet access and other high speedInternet connectivity technologies. 

**Our revenues may be negatively affected if we are required to charge taxes onpurchases.**

          We do not collect orhave imposed upon us sales or other taxes related to the products we sell,except for certain corporate level taxes and sales taxes with respect topurchases shipped to customers located in the states of Florida, Nevada andVirginia. However, one or more states or foreign countries may seek to imposesales or other tax collection obligations on us in the future. A successfulassertion by one or more states or foreign countries that we should becollecting sales or other taxes on the sale of our products could result insubstantial tax liabilities for past sales, discourage customers from purchasingproducts from us, decrease our ability to compete with traditional retailers orotherwise substantially harm our financial condition and results of operations.

          Currently, decisionsof the U.S. . Supreme Court restrict the imposition of obligations tocollect state and local sales and use taxes with respect to sales made over theInternet. However, implementation of the restrictions imposed by these SupremeCourt decisions is subject to interpretation by state and local taxingauthorities. While we believe that these Supreme Court decisions currentlyrestrict state and local taxing authorities outside the states of Florida,Nevada and Virginia from requiring us to collect sales and use taxes frompurchasers located within their jurisdictions, taxing authorities outside thestates of Florida, Nevada and Virginia could disagree with our interpretation ofthese decisions. Moreover, a number of states, as well as the U.S. Congress,have been considering various initiatives that could limit or supersede theSupreme Court’s position regarding sales and use taxes on Internet sales.If any state or local taxing jurisdiction were to disagree with ourinterpretation of the Supreme Court’s current position regarding state andlocal taxation of Internet sales, or if any of these initiatives were to addressthe Supreme Court’s constitutional concerns and result in a reversal of itscurrent position, we could be required to collect sales and use taxes frompurchasers located in states other than Florida, Nevada and Virginia. Theimposition by state and local governments of various taxes upon Internetcommerce could create administrative burdens for us and could decrease ourfuture revenues. 

**Government regulation of the Internet and e-commerce is evolving andunfavorable changes could substantially restrict our ability to do business andharm our financial condition and results of operations.**

          We are subject togeneral business regulations and laws as well as regulations and lawsspecifically governing the Internet and e-commerce. Existing and future laws andregulations may impede the growth of the Internet or other online services.These regulations and laws may cover taxation, restrictions on imports andexports, customs, tariffs, user privacy, data protection, pricing, content,copyrights, distribution, electronic contracts and other communications,consumer protection, the provision of online payment services, broadbandresidential Internet access and the characteristics and quality of products andservices. It is not clear how existing laws governing issues such as propertyownership, sales and other taxes, libel and personal privacy apply to theInternet and e-commerce. Unfavorable resolution of these issues maysubstantially harm our financial condition and results of operations. 

**Our failure to protect confidential information of our customers and ournetwork against security breaches could damage our reputation and brand andsubstantially harm our financial condition and results ofoperations.**

          A significantpredicate for online commerce and communications is customer confidence in thesecure transmission of confidential information over public networks, and afailure to prevent security breaches could damage our reputation and brand andsubstantially harm our business and results of operations. Currently, asignificant number of our customers authorize us to bill their credit cardaccounts directly. We rely on encryption and authentication technology licensedfrom third parties to effect secure transmission of confidential information,including credit card numbers. Advances in computer capabilities, newdiscoveries in the field of cryptography or other developments may result in acompromise or breach of the technology used by us to protect customertransaction data.

23

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Any such compromise of our security could damage our reputation and brands andexpose us to a risk of loss or litigation and possible liability which wouldsubstantially harm our business and results of operations. In addition, anyonewho is able to circumvent our security measures could misappropriate proprietaryinformation or cause interruptions in our operations. We may need to expendsignificant resources to protect against security breaches or to addressproblems caused by breaches. 

**Interruptions to our systems that impair customer access to our websiteswould damage our reputation and brands and substantially harm our financialcondition and results of operations.**

          The satisfactoryperformance, reliability and availability of our websites, transactionprocessing systems and network infrastructure are critical to our reputation andour ability to attract and retain customers and to maintain adequate customerservice levels. Any future systems interruption that results in theunavailability of our websites or reduced order fulfillment performance couldresult in negative publicity, damage our reputation and brands and cause ourbusiness and results of operations to suffer. Although we have not experiencedany material disruption in our services to date, we may be susceptible to suchdisruptions in the future. We may also experience temporary system interruptionsfor a variety of other reasons in the future, including power failures, softwareerrors or an overwhelming number of visitors trying to reach our websites duringperiods of strong demand or promotions. Because we are dependent in part onthird parties for the implementation and maintenance of certain aspects of oursystems, and because some of the causes of system interruptions may be outsideof our control, we may not be able to remedy such interruptions in a timelymanner, or at all.  

**Our failure to address risks associated with credit card fraud could damageour reputation and brands and may cause our financial condition and results ofoperations to suffer.**

          Under current creditcard practices, we are liable for fraudulent credit card transactions because wedo not obtain a cardholder’s signature. We do not currently carry insuranceagainst this risk. To date, we have experienced minimal losses from credit cardfraud, but we face the risk of significant losses from this type of fraud as ourrevenues increase. Our failure to adequately control fraudulent credit cardtransactions could damage our reputation and brands and substantially harm ourfinancial condition and results of operations. 

**Our failure to rapidly respond to technological change could result in ourservices or systems becoming obsolete and substantially harm our financialcondition and results of operations.**

          As the Internet andonline commerce industries evolve, we may be required to license emergingtechnologies useful in our business, enhance our existing services, develop newservices and technologies that address the increasingly sophisticated and variedneeds of our prospective customers and respond to technological advances andemerging industry standards and practices on a cost-effective and timely basis.We may not be able to successfully implement new technologies or adapt ourwebsites, proprietary technologies and transaction-processing systems tocustomer requirements or emerging industry standards. Our failure to do so wouldsubstantially harm our financial condition and results of operations.

**Risks Related to Our Common Stock**

**The market price of our common stock may experience substantial fluctuationsfor reasons over which we have little control.**

          Our common stock istraded on The Nasdaq Capital Market. The stock price and the share tradingvolume for companies in the retail sales industry is subject to significantvolatility. Both company-specific and industry-wide developments, as well aschanges to the overall condition of the US economy and stock market, may causethis volatility. The market price of our common stock could fluctuate up or downsubstantially based on a variety of factors, including the following:

|   | • | future announcements concerning us, our competitors, and the companies with whomwe have relationships or the online market for baby, toddler and maternityproducts; |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                |
|   | • | changes in operating   results from quarter to quarter;                                                                                                             |

24

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|   | • | sales of stock by   insiders;                       |
|--------|--------|-----------------------------------------------------|
|   |   |                                                |
|   | • | changes in government   regulations;                |
|   |   |                                                |
|   | • | changes in estimates by   analysts;                 |
|   |   |                                                |
|   | • | news reports relating to   trends in our markets;   |
|   |   |                                                |
|   | • | the seasonal nature of the   retail sales industry; |
|   |   |                                                |
|   | • | acquisitions and   financings in our industry; and  |
|   |   |                                                |
|   | • | the overall volatility of   the stock market.       |

Furthermore, stock prices for many companies fluctuate widely for reasons thatmay be unrelated to their operating results. These fluctuations, coupled withchanges in our results of operations and general economic, political and marketconditions, may adversely affect the market price of our commonstock.

**Our single largest shareholder and our management team collectively ownapproximately 47.0% of our common stock and may be able to exercise significantinfluence over the outcome of matters to be voted on by ourshareholders.**

          As of March 20,2007, John C. Textor, the other members of our management team, and certain ofMr. Textor’s affiliates that he controls, together beneficially ownedapproximately 47.0% of the outstanding shares of our common stock.  Mr.Textor is the Chairman of our Board of Directors and our Chief ExecutiveOfficer. Accordingly, Mr. Textor, together with the other members of ourmanagement team, may be able to exercise significant influence with respect tothe election of directors, offers to acquire us and other matters submitted to avote of our shareholders.

**Risks Related to Our Proposed Merger with eToys Direct**

**Failure to complete the Merger may result in our obligation to pay atermination fee to eToys Direct and could harm our common stock price and futurebusiness and operations.**

          If the merger witheToys Direct is not completed, we may be subject to the following risks:

|   | • | if the Merger Agreement is terminated under certain circumstances, we will berequired to pay eToys Direct a termination fee of $1,567,178, and reimburseeToys Direct for the expenses incurred by it in connection with the transactionin a maximum amount of $1,500,000; |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                      |
|   | • | the price of our common   stock may decline; and                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                      |
|   | • | costs incurred by us related to the Merger, such as legal, accounting andcertain financial advisory fees, must be paid by us even if the Merger is notcompleted.                                                                                                          |

In addition, if the Merger Agreement is terminated and our Board of Directorsdetermines to seek another business combination, there can be no assurance thatwe will be able to find a partner willing to provide equivalent or moreattractive consideration than the consideration to be provided in the Merger.

25

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**The market price of our common stock may decline as a result of a completedmerger with eToys Direct.**

          The market price ofour common stock may decline as a result of the Merger for a number of reasonsincluding if: 

|   | • | the combined company does not achieve the perceived benefits of the Merger asrapidly or to the extent anticipated by financial or industryanalysts;        |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                       |
|   | • | the effect of the Merger on the combined company’s business and prospectsis not consistent with the expectations of financial or industry analysts;or |
|   |   |                                                                                                                                                       |
|   | • | investors react negatively to the effect on the combined company’s businessand prospects of the Merger.                                               |

**Our shareholders may not realize a benefit from the Merger commensurate withthe ownership dilution they will experience in connection with the Merger. **

          If the combinedcompany is unable to realize the strategic and financial benefits currentlyanticipated from the Merger, our shareholders will have experienced substantialdilution of their ownership interest without receiving a commensurate benefit.

**During the pendency of the Merger, we may not be able to enter into abusiness combination with another party at a favorable price because ofrestrictions in the Merger Agreement. **

          Covenants in theMerger Agreement impede our ability to make acquisitions or complete othertransactions that are not in the ordinary course of business pending completionof the Merger.  As a result, if the Merger is not completed, we may be at adisadvantage to our competitors as a result of these foregoneopportunities.  In addition, while the Merger Agreement is in effect,subject to very narrowly defined exceptions, we are prohibited from soliciting,initiating, encouraging or entering into certain extraordinary transactions,such as a merger, sale of assets or other business combination outside theordinary course of business, with any third party.  

**If we do not successfully integrate our and eToys Direct’s businessoperations following a consummation of the Merger, the anticipated benefits ofthe Merger may not be fully realized or may not occur for an extended period oftime.**

          If we do notsuccessfully integrate the two companies upon completion of the Merger, theanticipated benefits of the Merger may not be fully realized or may not occurfor an extended period of time. No assurance can be given that we will be ableto integrate the two companies’ operations without encounteringdifficulties, including, without limitation, the loss of key employees andcustomers, the disruption of respective ongoing businesses or possibleinconsistencies in standards, controls, procedures and policies. Successful integration of our businesses with eToys Direct’s businesseswill depend primarily on our ability to consolidate operations, systems andprocedures of the two companies. There can be no assurance that we will succeedin these consolidation efforts.   

| **ITEM 1B.** | **UNRESOLVED   STAFF COMMENTS** |
|--------------|---------------------------------|

          None.

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| **ITEM 2.** | **PROPERTIES** |
|-------------|----------------|

          We do not ownany real property.  We lease approximately 9,700 square feet of officespace in Jupiter, Florida. The lease commenced on April 1, 2006 for a5-year and 9-month term, and the monthly lease cost is approximately $25,000.

          We lease9,800 square feet of office and warehouse space in Ft. Lauderdale,Florida that previously served as our corporate headquarters and distributioncenter under a lease that expires in May 2008.  In June 2006, the Companyentered into an agreement to sub-lease this space through April 30,2008**.**

          On December 15, 2005we entered into a lease for approximately 23,000 square feet of warehousespace for a new distribution center in Las Vegas, Nevada that replaced theBabyUniverse distribution center in Ft. Lauderdale, Florida and the DreamtimeBaby warehouse in Culver City, California.

          We leasedapproximately 4,000 square feet of office and warehouse space for ourDreamtime Baby business in Culver City, California under a lease that expired onMarch 31, 2006.  Prior to that time, Dreamtime Baby’s inventory andcertain of its employees were relocated to the Company’s new distributioncenter in Las Vegas, Nevada. 

          We leasedapproximately 7,625 square feet of office and warehouse space for the PoshTotsheadquarters in Virginia under a lease that expired on August 31, 2006. OnFebruary 28, 2006 we entered into a lease for approximately 12,000 square feetof office and warehouse space in Richmond, Virginia to replace the existingPoshTots headquarters space.

| **ITEM 3.** | **LEGAL   PROCEEDINGS** |
|-------------|-------------------------|

          We are not involvedin any material litigation, administrative or governmental proceeding and noneis believed by our management to be threatened.  

| **ITEM 4.** | **SUBMISSION   OF MATTERS TO A VOTE OF SECURITY HOLDERS** |
|-------------|-----------------------------------------------------------|

          No matters weresubmitted to a vote of security holders during the fourth quarter of2006.

27

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**PART II**

| **ITEM 5.** | **MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS ANDISSUER PURCHASES OF EQUITY SECURITIES** |
|-------------|----------------------------------------------------------------------------------------------------------------------|

|   | Our stock began trading on The Nasdaq Capital Market on March 27, 2006, aftertrading on the American Stock Exchange since August 3, 2005. At the same time,we changed our trading symbol from “BUN” to “POSH.” The following table shows the high and low trading prices for our common stock,as reported by the American Stock Exchange from August 3, 2005 through March 24,2006, and as reported by The Nasdaq Capital Market from March 27, 2006 throughDecember 29, 2006.  The prices shown have been rounded to the nearest$1/100.  As of March 27, 2007, the approximate number of shareholders ofrecord of the Company’s common stock was 26, and the approximate number ofbeneficial owners of the Company’s common stock was 1,621. |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|           |   | **2006** |   | **2005** |   |
|----------------|--------|----------|--------|----------|--------|
|           |   |          |   |          |   |
|           |   | **High** |   | **Low**  |   | **High** |   | **Low** |   |
|           |   |          |        |     |        |  |   |  |  |   |  |  |   |
| First Quarter  |   | $        | 10.50  |     | $      | 7.95 |   |   | —   |   |   | —   |   |
| Second Quarter |   | $        | 10.25  |     | $      | 7.17 |   |   | —   |   |   | —   |   |
| Third Quarter  |   | $        | 9.09   |     | $      | 6.85 |   | $ | 12.00 |   | $ | 7.70 |   |
| Fourth Quarter |   | $        | 8.25   |     | $      | 6.57 |   | $ | 9.80 |   | $ | 7.10 |   |

|   | We have not paid a dividend on any class of common stock and anticipate that wewill retain future earnings, if any, to fund the development and growth of ourbusiness. Consequently, we do not anticipate paying cash dividends on our commonstock in the foreseeable future.                                                                                                                                                                                                                                                                                                                          |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   | **Performance Graph**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   | *The information contained in this Performance Graph section of this Item 5 shallnot be deemed to be “soliciting material” or “filed” orincorporated by reference in future filings with the Securities and ExchangeCommission (“SEC”), or subject to the liabilities of Section 18 of theSecurities Exchange Act of 1934, except to the extent that the Companyspecifically incorporates it by reference into a document filed under theSecurities Act of 1933 or the Securities Exchange Act of 1934.*                                                                 |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   | The graph below compares the performance of the Company’s Common Stock withthe performance of the S&P 500 Index and a peer group index (the “PeerGroup Index”) by measuring the respective changes in common stock pricesfrom August 3, 2005, the first day of trading of the Company’s Common Stockafter our initial public offering, through December 31, 2006, the last day ofour 2006 fiscal year.  The Company’s Common Stock ceased trading onthe American Stock Exchange on March 24, 2006, and on March 27, 2006, begantrading on The Nasdaq Capital Market. |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   | Pursuant to the SEC’s rules, the Company created a peer group index withwhich to compare its own stock performance. The Company has selected a groupingof companies that it believes share similar characteristics to its own. Thecompanies included in the Peer Group Index are as follows: Amazon.com Inc., BlueNile Inc., iVillage Inc., Knot Inc., Odimo Inc. and RedEnvelope Inc.                                                                                                                                                                                                            |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|   | The graph assumes that $100 was invested on August 3, 2005 in each of theCompany’s Common Stock, the S&P 500 Index and the Peer Group Index, andthat all dividends were reinvested into additional shares of the same class ofequity securities at the frequency with which dividends are paid on suchsecurities during the applicable fiscal year. The Peer Group Index weighs thereturns of each constituent company according to its stock market capitalizationat the beginning of each period for which a return is indicated.                                                           |

**INDEXED RETURNS****Months Ending**

| **Company Name / Index** |   | **Base   Period   8/3/05** |    | **8/31/05** |   | **9/30/05** |   | **10/31/05** |   | **11/30/05** |   | **12/31/05** |   | **1/31/06** |   | **2/28/06** |   | **3/31/06** |   |
|--------------------------|--------|----------------------------|---------|-------------|--------|-------------|--------|--------------|--------|--------------|--------|--------------|--------|-------------|--------|-------------|--------|-------------|--------|
|                          |   |                            |         |        |        |             |   |              |        |         |        |              |   |             |        |        |        |             |   |  |  |   |  |  |   |  |  |   |
| **BabyUniverse, Inc.**   |   |                       | **100** |        |   | 100.11      |   |         | 89.47  |         |   | 86.84        |   |        | 95.79  |        |   | 88.21       |   |   | 95.26 |   |   | 87.89 |   |   | 101.89 |   |
| **S&P 500 Index**    |   |                       | **100** |        |   | 98.22       |   |         | 99.02  |         |   | 97.37        |   |        | 101.05 |        |   | 101.09      |   |   | 103.76 |   |   | 104.04 |   |   | 105.34 |   |
| **Peer Group**           |   |                       | **100** |        |   | 93.39       |   |         | 98.84  |         |   | 88.35        |   |        | 106.62 |        |   | 103.65      |   |   | 98.73 |   |   | 83.81 |   |   | 82.57 |   |

| **Company Name / Index** |   | **4/30/06** |   | **5/31/06** |   | **6/30/06** |   | **7/31/06** |   | **8/31/06** |   | **9/30/06** |   | **10/31/06** |   | **11/30/06** |   | **12/31/06** |   |
|--------------------------|--------|-------------|--------|-------------|--------|-------------|--------|-------------|--------|-------------|--------|-------------|--------|--------------|--------|--------------|--------|--------------|--------|
|                          |   |             |        |        |        |             |   |             |        |        |        |             |   |              |        |         |        |              |   |  |  |   |  |  |   |  |  |   |
| **BabyUniverse, Inc.**   |   |        | 94.32  |        |   | 99.47       |   |        | 88.53  |        |   | 82.53       |   |         | 77.37  |         |   | 79.26        |   |   | 84.74 |   |   | 74.95 |   |   | 76.32 |   |
| **S&P 500 Index**    |   |        | 106.75 |        |   | 103.68      |   |        | 103.82 |        |   | 104.46      |   |         | 106.95 |         |   | 109.70       |   |   | 113.28 |   |   | 115.43 |   |   | 117.05 |   |
| **Peer Group**           |   |        | 79.93  |        |   | 78.06       |   |        | 87.37  |        |   | 61.75       |   |         | 70.47  |         |   | 74.03        |   |   | 87.01 |   |   | 91.81 |   |   | 90.00 |   |

**THE STOCK PRICE PERFORMANCE DEPICTEDIN THE PERFORMANCE GRAPH IS NOT NECESSARILY INDICATIVE OF FUTURE PRICEPERFORMANCE. THE PERFORMANCE GRAPH WILL NOT BE DEEMED TO BE INCORPORATED BYREFERENCE IN ANY FILING BY THE COMPANY UNDER THE SECURITIES ACT OF 1933 OR THESECURITIES EXCHANGE ACT OF 1934.**

|   | **Equity Compensation Plan Information
 

 

 

Information with respect to compensation plans under which equity securities ofthe Company are authorized for issuance is presented in Item 12 of this AnnualReport on Form 10-K under the caption “Equity Compensation PlanInformation”, and is incorporated into this Item 5 by thisreference.

 

 

 

**Issuance of Unregistered Securities
 

 

 

On September 22, 2006, BabyUniverse, Inc. closed on $2 million in new equityfinancing.  The equity financing was provided by affiliates of WyndcrestHoldings, LLC, a company controlled by John C. Textor, our Chief ExecutiveOfficer. In connection with the financing, the Company received aggregateproceeds of approximately $2 million, based on the issuance of 263,852 shares ofcommon stock priced at $7.58 per share, a 7.5% premium to the closing price onSeptember 22, 2006.  These funds are to be used for general corporatepurposes. The shares of the common stock issued in this private placement werenot registered under the Securities Act of 1933, pursuant to the exemptionprovided in Section 4(2)) thereof, and may not be subsequently offered or soldby the investors in the United States absent registration or an applicableexemption from the registration requirements. BabyUniverse filed a RegistrationStatement on Form S-3 (No. 333-139712) on December 28, 2006 coveringregistration of the common stock acquired by the investors pursuant to theprivate placement.  This Registration Statement became effective on January24, 2007.

 

 

 

On January 13, 2006, through a wholly owned subsidiary, we acquiredsubstantially all of the assets of Posh Tots, LLC, in exchange for $6.0 millionin cash, a Promissory Note for $6.0 million, 237,248 shares of our common stockand warrants to purchase 110,000 shares of our common stock at a price of $8.10per share, which warrants became exercisable on January 13, 2007 and expire onJanuary 13, 2008. The securities issued pursuant to this acquisition were notregistered under the Securities Act of 1933, pursuant to the exemption providedin Section 4(2)) thereof, and may not be subsequently offered or sold in theUnited States absent registration or an applicable exemption from theregistration requirements.

28

**ITEM 6.**

**SELECTED   FINANCIAL DATA**

          The following tablesets forth selected consolidated financial data for each of the Company’sfive most recent fiscal years.  You should read the following selectedconsolidated financial data in conjunction with Part II, Item 7 of this AnnualReport on Form 10-K, “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations”, and our consolidatedfinancial statements and the notes thereto appearing elsewhere in this AnnualReport on Form 10-K.  The comparability of certain of such data relating tothe Company’s fiscal year ended December 31, 2006 with the correspondingdata for the prior periods may be affected by the events and actions describedin Management’s Discussion and Analysis of Financial Condition and Resultsof Operations – Recent Developments – Operational Restructuring andReorganization, and – Current Operating Environment.

 

 

**Year Ended   December 31,**

 

 

 

 

 

 

**2006**

 

**2005**

 

**2004**

 

**2003**

 

**2002**

 

 

 

 

 

 

 

 

 

 

**(in   thousands, except share data)**

 

**Consolidated   Statements of Operations Data:**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

35,550

 

$

23,702

 

$

14,267

 

$

8,842

 

$

5,012

 

Cost of goods sold

 

 

25,390

 

 

17,417

 

 

10,591

 

 

6,405

 

 

3,637

 

 

 

 

 

 

 

 

Gross profit

 

 

10,160

 

 

6,285

 

 

3,676

 

 

2,437

 

 

1,375

 

Operating expenses

 

 

14,551

 

 

6,927

 

 

3,456

 

 

2,597

 

 

1,722

 

 

 

 

 

 

 

 

Operating income (loss)

 

 

(4,391

)

 

(642

)

 

220

 

 

(160

)

 

(347

)

Other income (expenses)

 

 

1,048

 

 

178

 

 

1

 

 

(41

)

 

`

 

 

 

 

 

 

 

 

Income (loss) before income   taxes

 

 

(3,343

)

 

(464

)

 

221

 

 

(201

)

 

(347

)

Provision (benefit) for   income taxes (1)

 

 

—  

 

 

28

 

 

—  

 

 

—  

 

 

—  

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(3,343

)

$

(492

)

$

221

 

$

(201

)

$

(347

)

 

 

 

 

 

 

 

Earnings (loss) per common   share

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

(.62

)

$

(0.13

)

$

0.10

 

$

(0.19

)

$

(0.40

)

 

 

 

 

 

 

 

Diluted

 

$

(.62

)

$

(0.13

)

$

0.07

 

$

(0.19

)

$

(0.40

)

 

 

 

 

 

 

 

Weighted average common   shares outstanding

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

5,419,872

 

 

3,667,913

 

 

2,285,382

 

 

1,073,369

 

 

857,386

 

Diluted

 

 

6,106,369

 

 

4,142,075

 

 

2,999,169

 

 

2,960,294

 

 

1,204,806

 

 

 

**Year Ended   December 31,**

 

 

 

 

 

 

**2006**

 

**2005**

 

**2004**

 

**2003**

 

**2002**

 

 

 

 

 

 

 

 

 

 

**(in   thousands)**

 

**Consolidated   Balance Sheets Data:**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash

 

$

3,473

 

$

9,926

 

$

613

 

$

223

 

$

97

 

Working capital

 

 

(44

)

 

8,655

 

 

(727

)

 

(770

)

 

(700

)

Total assets

 

 

30,304

 

 

19,737

 

 

1,373

 

 

409

 

 

366

 

Notes and Capital Leases Payable – Noncurrent 

 

$

5,778

 

 

5

 

 

—  

 

 

—  

 

 

—  

 

Total shareholders’ equity   (deficit)

 

 

17,706

 

 

16,145

 

 

(466

)

 

(690

)

 

(599

)

(1)  We did not pay federal income taxes in 2002, 2003, 2005 or 2006due to our net losses, nor in 2004 due to the application of net loss carryforwards. As of December 31, 2006, we had approximately $6,900,000 of net losscarry forwards, which expire in various years through 2026.

**ITEM 7.**

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

          *In addition tohistorical information, this Annual Report on Form 10-K contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933 andSection 21E of the Securities Exchange Act of 1934. These statements include,among other things, statements regarding our future operations, financialcondition, prospects and business strategies, and the consummation of ourproposed merger with eToys Direct, Inc. These forward-looking statements aresubject to certain risks and uncertainties that could cause our actual resultsto differ materially from those reflected in the forward-looking statements.Factors that could cause or contribute to such differences include, but are notlimited to, those discussed in this Annual Report on Form 10-K, and inparticular, the risks discussed under the heading “Risk Factors” inPart I, Item 1A of this Annual Report on Form 10-K and those discussed in otherdocuments we file with the Securities and Exchange Commission. We undertake noobligation to revise or publicly release the results of any revision to theseforward-looking statements. Given these risks and uncertainties, readers arecautioned not to place undue reliance on such forward-looking statements.*

29

*          The followingdiscussion and analysis of financial condition and results of operations shouldbe read together with “Selected Financial Data,” and our financialstatements and accompanying notes appearing elsewhere in this Annual Report onForm 10-K.*

**Overview**

          BabyUniverse is aleading Internet content, commerce and new media company in the pregnancy, baby,toddler and maternity marketplace.  Through its websites BabyUniverse.comand DreamtimeBaby.com, the Company is a leading online retailer of brand-namebaby, toddler and maternity products in the United States.  Throughits  websites PoshTots.com and PoshLiving.com, the Company has extended itsofferings in the baby and toddler market as a leading online provider of luxuryfurnishings to the country’s most affluent female consumers.  Throughits websites PoshCravings.com, ePregnancy.com and BabyTV.com, BabyUniverse hasalso established a recognized platform for the delivery of content and new mediaresources to a national audience of expectant parents. 

          BabyUniverse ispursuing a dual strategy of organic growth and acquisition growth that isdesigned to establish BabyUniverse as the leader in the online baby marketplace.Beyond the baby segment, the Company intends to leverage its efficient andgrowing e-commerce platform to acquire other female-oriented e-commerce,marketing and new media companies. The overall objective of BabyUniverse is toestablish a market-leading e-commerce and new media business focused on thehigh-growth female marketplace.

          According to theUnited States Department of Commerce, the total online market for consumerproducts grew at a compound annual growth rate of 25.2% from $28.0 billionin 2000 to $86.3 billion in 2005.  In the third quarter of 2006, thismarket continued expanding by growing 20.9% over the third quarter of2005.  Furthermore, the percentage of retail Internet sales occurring inthe United States compared to total sales occurring at retail in the UnitedStates has increased from 0.9% in 2000 to 2.8% in the third quarter of2006.  eMarketer, Inc., a leading aggregator of online research reports,predicts that online retail sales will rise to $121 billion by 2007, or2.9% of total retail sales. In addition, independent reports, including a May2005 study by Forrester Research and a May 2005 report by e-Marketer, haveindicated that women are becoming a more powerful driver of this growth inonline purchasing activity. As the total online retail market continues to grow,we believe that the market for baby, toddler and maternity products sold overthe Internet will also grow and that we are strategically positioned toparticipate substantially in such growth. 

          We offer over 35,000products from over 600 manufacturers in easy-to-use online shopping environmentsthat include baby, toddler and maternity accessories, apparel, bedding,furniture, toys and gifts. These products are available in a variety of styles,colors and sizes which account for over 750,000 stock keeping units(“SKUs”). We also provide expert buyer’s guides and in-depthproduct descriptions to assist our customers with finding quality products andto help parents make informed decisions about their babies’ andtoddlers’ needs and safety.  Overall, we provide a compellingcombination of high quality products at competitive prices, a convenientshopping experience and excellent customer service that allows us to build anongoing and potentially long-term relationship with our customers. 

          We review ouroperations based on both our financial results and various non-financialmeasures. Among the key financial factors upon which management focuses inreviewing performance are growth in sales, gross margin and operating income (orloss).  As an online retailer, we do not incur many of the operating costsassociated with physical retail stores. However, a significant amount of ouroperating expenses, as a percentage of net sales, is spent on online advertisingand commissions instead of maintaining physical retail stores and salesstaff.  Our advertising and commission spending is an important factor inour sales growth, and we continuously monitor its effectiveness.  Ourfinancial results, including our sales, gross profit and operating income (orloss) can and do vary significantly from quarter to quarter as a result of anumber of factors, many of which are beyond our control. These factors includegeneral economic conditions, the costs to acquire our inventory and fulfillorders, the mix of our product sales and our competitors’ pricing andmarketing strategies.  Our total cost to fulfill orders is especiallysensitive to potential fuel cost increases that may result from a continuingdestabilization of world energy markets. 

          We generally own andhold only a portion of the inventory needed to support our level of sales.Although we are continuing to increase inventory of those items with lower riskdue to higher demand and turnover, a significant portion of the inventory weoffer is owned by our suppliers. This enables us to reduce some of the cost andrisk associated with carrying a full inventory of the products we sell. Uponreceipt of a customer order for a specific product that will be drop-shippedfrom a supplier, we simultaneously purchase that product from our supplier, whoships it directly to our customer. Since our inception, our business model hasminimized inventory risk by maximizing the number of products we sell that areowned by others. However, as we execute our acquisition strategy, we may acquirebusinesses that use a different inventory model. 

30

          Among the keynon-financial measures which management reviews are customer feedback, websitetraffic, sales conversion rates (*i.e.,* the percentage of visitors to ourwebsites who make a purchase) and number of orders. We believe that maintaininghigh overall customer satisfaction and an enjoyable shopping experience arecritical to our ongoing efforts to promote our brands and to increase our salesand net income. We actively solicit customer feedback about our websites’functionality as well as the entire shopping experience through third-partybusiness rating and price comparison websites such as Shopping.com andBizRate.com. To maintain a high level of performance by our customer carerepresentatives, we also undertake an ongoing customer feedback process. If weare unable to meet customer expectations with respect to price or do notsuccessfully expand our product lines or otherwise fail to maintain high overallcustomer satisfaction, our financial condition and results of operations wouldbe harmed. 

          We believethat we are one of the largest online retailers of baby, toddler and maternityproducts in terms of product offerings and revenues. As an industry leader, wehave grown our business internally since inception by increasing our presence inwhat we have identified to be the largest and most efficient Internet portalsand by keyword paid search advertising, resulting in substantially increasedtraffic to our websites. We have also increased our sales conversion rate bybroadening our product offerings and by actively managing the placement of thebest-selling products on our websites. As a result, our sales have increasedsubstantially year over year since our inception.

          The marketfor online retailers offering baby, toddler and maternity related products ishighly fragmented, with a significant number of small competitors representing asignificant percentage of total segment sales. We believe that our seasonedsenior management team and our scalable business architecture make uswell-suited to acquire both large and small industry competitors. As part of ouracquisition strategy, we intend to preserve the goodwill and marketingrelationships of acquired companies as necessary to maintain and grow marketshare. In addition, we may acquire companies that market products predominantlyto women over the Internet, or companies that enhance our ability to marketproducts to women.

**Recent Developments**

***Strategic Alternatives***

          On August 14, 2006,BabyUniverse announced that its Board of Directors decided to begin a process toexplore strategic alternatives to enhance shareholder value including, but notlimited to, the acquisition of a substantial private company, the acquisition ofa complementary public company or a potential sale of the Company. On October 5,2006, the Company announced that it had retained Banc of America Securities LLCas its financial advisor.  There can be no assurance that a transactionwill result from this process and the Company does not intend to disclosedevelopments regarding its exploration unless and until the Company’s Boardof Directors has approved a specific transaction.

          On March 13,2007, the Company entered into a definitive Agreement and Plan of Merger (the“Merger Agreement”) with eToys Direct, Inc. (“eToysDirect”), an e-commerce and direct marketer of toys and other youth-relatedproducts.  Under the terms of the Merger Agreement, which has been approvedby the Company’s Board of Directors, the Company will exchange shares ofits Common Stock, par value $0.001 per share (the “Common Stock”), forall the outstanding shares of eToys Direct.  Immediately following themerger contemplated by the Merger Agreement (the “Merger”),BabyUniverse shareholders at the time immediately prior to the Merger will ownapproximately one-third, and eToys Direct shareholders at the time immediatelyprior to the Merger will own approximately two-thirds, of the outstanding CommonStock.

31

          The Company andeToys Direct have made customary representations, warranties and covenants toone another in the Merger Agreement.  Consummation of the Merger is subjectto certain conditions, including, among others, the approval of the MergerAgreement by the holders of the Common Stock, the repayment by the Company ofall of its indebtedness for borrowed money outstanding as of the closing of theMerger, and the absence of any law or order prohibiting the consummation of theMerger. The Merger Agreement contains certain termination rights for both theCompany and eToys Direct, and further provides that, upon termination of theMerger Agreement under specified circumstances, the Company may be required topay eToys Direct a termination fee of $1,567,178, and reimburse eToys Direct forthe expenses incurred by it in connection with the transaction in a maximumamount of $1,500,000.   

***PoshTots Acquisition***

          On January 13, 2006,through our wholly owned subsidiary PoshTots, Inc., we acquired substantiallyall of the assets of Posh Tots, LLC (“PoshTots”), in exchange for $6.0million in cash, a promissory note for $6.0 million, 237,248 shares of ourcommon stock and warrants to purchase 110,000 shares of our common stock at aprice of $8.10 per share.  Through its primary website, PoshTots.com, theRichmond, Virginia-based PoshTots has long been recognized as a leading onlineretailer of high-end, artisan-crafted furniture to this country’s mostaffluent new mothers.  Beyond the baby and children’s segments,PoshTots recently extended its brand with the Fall 2005 introduction of a newwebsite, www.PoshLiving.com, offering designer quality home furnishings to itsexisting and growing base of affluent, predominantly female, customers.  InMarch 2006, PoshTots introduced another new website, www.PoshCravings.com,designed as a content driven initiative targeted at the affluent female customerbase already developed by PoshTots.

***Purchase of Selected ePregnancy Assets***

          On June 15, 2006,the Company acquired certain assets related specifically to the business ofePregnancy.com and ePregnancy Magazine.  The selected assets acquiredinclude the URL www.ePregnancy.com, the ePregnancy trademark, a related onlinecommunity website, message boards, and an expansive archive of content. Themagazine’s prior owners discontinued publication of ePregnancy Magazine andthe final published issue was distributed in late April as the May 2006issue.  BabyUniverse intends to focus its efforts on growing and supportingthe online community at ePregnancy.com and does not intend to revive themagazine. The acquisition of these assets furthers the overall objective ofBabyUniverse, which is to establish a market-leading e-commerce and new mediabusiness focused on the high-growth female marketplace. 

***Debt Financing Transactions***

          On July 11, 2006,the Company completed a $5.0 million debt financing transaction with HerculesTechnology Growth Capital, Inc. (“Hercules”). Proceeds from thefinancing were used primarily to refinance the Company’s existing debt tothe former owners of PoshTots, thereby enabling the Company to realize anegotiated $1.5 million discount of the $6.0 million note.  The pre-paymentand principal reduction in the note payable of $1.5 million was recognized inother income and expense as a gain on early extinguishment of debt in accordancewith the accounting treatment prescribed by Accounting Principles Board Opinion(“APB”) 26, *Early Extinguishment of Debt*, and Statement ofFinancial Accounting Standards (“SFAS”) No. 145, *Rescission ofFASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, andTechnical Corrections*.  The Company previously stated in its QuarterlyReport on Form 10-Q for the quarter ended June 30, 2006 (See Note 9 to theunaudited financial statements contained therein – Subsequent Event)that,**“**The pre-payment and principal reduction in the note payablesubsequent to June 30, 2006 will reduce the Company’s goodwill amountrelated to the PoshTots acquisition by $1.5 million.” This initialdetermination as to the proposed accounting treatment was based on limitedconsideration at that time of the relevant accounting pronouncements applicableto the underlying facts of this transaction. Based on subsequent review andconsideration, the Company believes that SFAS 141, “BusinessCombinations”, is not relevant to the essential facts of this transaction.

          The Senior Loan andSecurity Agreement between Hercules and the Company (the “Hercules LoanAgreement”) is for a term of 36 months, at an interest rate equal to theprime interest rate plus 2.35%. The Hercules Loan Agreement allows forinterest-only payments for 12 months, with principal and interest payments duemonthly thereafter. The interest-only period and the term of the underlying loan(the “Hercules Loan”) may be extended up to six months based onmeeting certain financial tests. The Hercules Loan is secured by a perfectedfirst priority security interest in all of the Company’s tangible andintangible assets and requires compliance with certain financial covenants,including a current ratio requirement, by which the Company must maintain acurrent ratio of at least .85 for the quarter ending September 30, 2006, atleast .90 for the quarter ending December 31, 2006, and at least 1.0 for eachsubsequent calendar quarter thereafter. The Company was in compliance with allsuch covenants as of December 31, 2006.

32

          In conjunction withthe Hercules Loan Agreement, the Company issued a warrant to Hercules topurchase 91,912 shares of common stock of the Company at an exercise price of$8.16 per share. The warrant vested immediately upon execution of the HerculesLoan Agreement and is exercisable for seven years. The fair value of the warrantas of July 11, 2006 is $333,034, and the pro-rata value of the warrant will beclassified as debt discount and amortized during the 36-month term of theHercules Loan in accordance with APB No. 14.

          On December 29,2006, the Company entered into a Loan Agreement (the “Lydian LoanAgreement”) with Lydian Private Bank, pursuant to which Lydian Private Bankprovided a term loan of $2,000,000 to the Company (the “Lydian Loan”),evidenced by a Promissory Note in that principal amount dated December 29, 2006(the “Lydian Note”). The Lydian Loan bears interest at a floating rateof interest equal to the base rate on corporate loans posted by at least 75% ofthe nation’s largest banks, known as the “Wall Street JournalPrime,” which interest is payable monthly beginning on February 1, 2007.The maturity date of the Lydian Loan is July 1, 2008, at which time alloutstanding principal and accrued but unpaid interest thereunder must be repaidto Lydian Private Bank. 

          As security for theLydian Loan, Wyndcrest BabyUniverse Holdings II, LLC, a Florida limitedliability company, and Wyndcrest BabyUniverse Holdings III, LLC, a Floridalimited liability company, each of which is controlled by John C. Textor, theCompany’s Chairman and Chief Executive Officer, pledged to Lydian PrivateBank shares of the Company’s common stock held by them, which shares alsoserve as collateral under a loan previously extended to such pledgors by LydianPrivate Bank. In addition, each such pledgor and Mr. Textor have executed aguaranty of the Lydian Loan in favor of Lydian Private Bank. The Lydian LoanAgreement and the Lydian Note contain customary events of default for facilitiesof this type; upon the occurrence of any such event of default, Lydian PrivateBank shall be entitled to all rights and remedies available to it against theCompany under law and the Lydian Loan Agreement and the Lydian Note, including,without limitation, the right to accelerate and demand immediate repayment ofall sums due thereunder.

***Private Placement of Equity Securities***

          On September 22,2006, BabyUniverse closed on $2 million in new equity financing.  Theequity financing was provided by affiliates of Wyndcrest Holdings, LLC, acompany controlled by the Company’s Chairman of the Board and ChiefExecutive Officer, John C. Textor.  In connection with the financing, theCompany received aggregate proceeds of approximately $2 million, based on theissuance of 263,852 shares of our common stock priced at $7.58 per share, a 7.5%premium to the closing price on September 22, 2006.  These funds are to beused for general corporate purposes.

          The shares of thecommon stock issued in this private placement were not registered under theSecurities Act of 1933, pursuant to the exemption provided in Section 4(2))thereof, and may not be subsequently offered or sold by investors in the UnitedStates absent registration or an applicable exemption from the registrationrequirements. BabyUniverse filed a Registration Statement on Form S-3 (No.333-139712) on December 28, 2006 covering registration of the common stockacquired by the investors pursuant to the private placement. This RegistrationStatement became effective on January 24, 2007.

33

***BabyTV.com***

          In December 2006 welaunched our flagship new media venture, BabyTV.com, the Internet’s firstintegrated television-style broadcast channel and social networking communityfocused on the needs of new and expectant parents.  BabyTV.com is deliveredthrough an interactive format in which the consumer can tune in tobroadcast-quality live and pre-recorded streaming television, interact throughlive events, respond to synchronized and targeted advertisements, engage ine-commerce transactions, browse links on the Web, and participate inBabyTV.com’s community features, without ever leaving the integratedbroadcast platform. 

          The primary goal ofBabyTV.com, and our other content sites, PoshCravings.com and ePregnancy.com, isto increase revenues from advertisers. We also intend BabyTV.com to build forour e-commerce sites the kind of loyalty with consumers that can be difficult toachieve in a pure e-commerce environment and to become a valuable driver of theBabyUniverse business strategy. 

          BabyTV.com hasalready partnered with the acclaimed women’s media company Oxygen MediaInteractive, Inc., as well as video-on-demand pioneer Alpha Mom TV, Inc., tobring a wealth of informative and entertaining programming to our viewers.Oxygen’s “Oh!Baby” video on-demand (VOD) programming contributessegments of their popular shows, with content celebrating the highs and lows ofparenthood. Alpha Mom contributes a deep catalog of informative programmingfeaturing recognized experts on important topics from pregnancy through earlychild development. We plan to utilize these partnerships to cross-market to the1.7 million monthly unique visitors of BabyUniverse-owned e-commerce propertiessuch as BabyUniverse.com, PoshTots.com and DreamTimeBaby.com, and to contentproperties such as PoshCravings.com and ePregnancy.com.  

***Amazon Content Agreement***

          In December 2006, wereached an agreement with Amazon.com, Inc. to provide the rich content of ourInternet sites, PoshCravings.com and ePregnancy.com, to Amazon.com consumersthrough the Amazon Baby marketplace.ePregnancy.com, a leading resource for boththe expectant mother and new moms, offers valuable expert information as well asa vibrant online community. PoshCravings.com, launched in March 2006, has becomea top style and trend destination for savvy moms and moms-to-be. Both sitesboast a loyal following of visitors who seek the best advice, tips and trends aswell as fabulous weekly giveaways. 

          Amazon is the firstsignificant strategic relationship designed to support our long-communicatedplan to transform BabyUniverse from a pure e-commerce company into a balancedcontent, commerce and new media concern. With an audience of more than 60million active customer accounts, Amazon presents an opportunity for nationalbrand prominence for our PoshCravings.com and ePregnancy.com contentproperties.

***Operational Restructuring and Reorganization***

          During the firstquarter of 2006, the Company initiated a multi-faceted reorganization andrestructuring plan (the “Plan”), which was essentially completedduring the second quarter of 2006. The objectives of the Plan were to (1)integrate the business operations of two recent acquisitions with theBabyUniverse e-commerce business in order to achieve greater efficiency, and (2)benefit from certain business strengths and best practices of the acquiredorganizations. The Plan was comprised of the following specificelements:

 

•

Open the Company’s new distribution center in 23,000 square feet of leasedspace in Las Vegas in January 2006.

 

 

 

 

•

Implement a new warehouse management system for the Las Vegas distributioncenter by late March 2006.

 

 

 

 

•

Relocate DreamtimeBaby’s business operations and inventory from its LosAngeles-area headquarters to the Las Vegas distribution center by late March2006.

 

 

 

 

•

Relocate the BabyUniverse inventory and distribution activities from its FortLauderdale warehouse to the Las Vegas distribution center during February2006.

 

 

 

 

•

Restructure the BabyUniverse e-commerce business operations by consolidatingsubstantially all activities within the PoshTots management organization inRichmond, Virginia during May 2006.

34

 

•

Reorganize and consolidate the senior management organization in corporateoffices in Jupiter, Florida during June 2006. The corporate office houses theCompany’s executive management organization and certain corporate servicesincluding strategic planning, finance, technology, logistics and new mediadevelopment.

          The restructuringexpenses related to the Plan were accounted for pursuant to SFAS No. 146,*Accounting for Costs Associated with Exit or Disposal Activities*, whichaddresses exit or disposal activities including one-time involuntary employeetermination benefits, contract termination costs and costs to consolidatefacilities or relocate employees.  The total expense incurred forrestructuring activities was approximately $538,000, of which $116,000 and$390,000 were recognized during the first and second quarters of 2006,respectively.

          The majorcosts associated with implementing the Plan were as follows:

 

•

One-time termination benefits were provided to certain current employees thatwere involuntarily terminated pursuant to the Plan, which was announced inFebruary 2006.  The affected employees were required to render servicethrough various dates to June 30, 2006 in order to receive the terminationbenefits. The total expense incurred for one-time termination benefits wasapproximately $111,000. Approximately $43,000 and $68,000 of one-timetermination benefits were recognized as restructuring expenses for the first andsecond quarters of 2006, respectively.

 

 

 

 

•

We ceased using leased space for our offices and warehouse in Fort Lauderdale,Florida during the second quarter of 2006. We have recognized a liability of$72,752 during the quarter ended June 30, 2006, which represents the fair valueof the lease costs that will continue to be incurred under the lease, net ofsub-lease opportunities, for its remaining term through May 2008.

 

 

 

 

•

Other costs incurred as a result of the restructuring include costs toconsolidate or close our facilities in Fort Lauderdale and Los Angeles and torelocate certain activities to the Las Vegas distribution center, toPoshTots’ headquarters in Richmond, Virginia and to our corporate office inJupiter, Florida. The total amount of other restructuring costs wasapproximately $323,000, most of which was incurred and recognized asrestructuring expenses in the second quarter of 2006.

          The Companyexperienced a significant amount of temporary but duplicative salary expenseduring the second quarter of 2006 due to the overlapping of positions during theextended training phase of its reorganization. A total of approximately 34positions were relocated, replaced and retrained during this reorganization, andthe cost of the overlapping salary expense included in restructuring expensesduring the second quarter amounted to $151,831. Most of this duplication ofsalary expense ended during the second quarter, and the remainder ended duringthe first half of the third quarter.

***Current Operating Environment***

          Throughout thisperiod of restructuring, reorganization and business integration that beganduring the first quarter of 2006, the Company experienced substantialoperational difficulties. Although the nature of these problems was anticipatedat the outset of the reorganization and integration projects, the extent of theoperating problems was not completely foreseen. These difficulties largelyresulted from the complexity of simultaneously integrating within ournewly-opened Las Vegas distribution center, both (1) the DreamtimeBaby businessoperations and inventory from their former location in Los Angeles, and (2) theBabyUniverse inventory and fulfillment operations from Fort Lauderdale. Thisconsolidation project was further complicated by software problems associatedwith the newly-introduced warehouse management system in the Las Vegasdistribution center, the additional complexity of relocating the BabyUniversecall center and much of its remaining business operations to PoshTots’Richmond headquarters, and also the relocation and consolidation of seniormanagement and the information technology, accounting and logistics functionsfrom former offices in Fort Lauderdale, Florida to new executive offices inJupiter, Florida. 

35

          During the secondquarter of 2006, as a result of the restructuring, reorganization and businessintegration, we experienced an increased incidence of delayed shipments ofcustomer orders, a higher level of order cancellations, and an increased levelof product returns and discounts. These problems continued, to a lesser degree,during the third quarter, as we continued to focus significant attention andresources on resolving the cause of the various problems. As a result, ourAmazon customer feedback has improved to a satisfaction score of more than 90%,from a low point in July 2006 of less than 60%.  

          However, thediversion of management’s attention from more normal activities during 2006significantly impacted our sales performance during this period. Although sitetraffic across the BabyUniverse.com website increased 15% and 20% in Septemberand October, respectively, compared to the same periods in the prior year, ourconversion rates were lower in those months compared to the same periods in theprior year. This was directly attributable to the reduced availability of highvelocity inventory items to fulfill sales orders due to organizational andprocedural issues involving inventory ordering and replenishment. Newly-appointed operations management, replenishment process reengineering, andcontinued training of newly-hired employees during 2006 are expected to improveinventory availability and reduce backorders prospectively.

          Our operatingresults during 2006 also were significantly impacted by increased salary andbenefits and general and administrative expenses incurred (1) to expand theplatform to support our acquisition growth strategy, and (2) to pursue therecent initiatives to expand our content and new media business, which iscomprised of PoshCravings.com, ePregnancy.com and BabyTV.com.

**Critical Accounting Policies**

          Our discussion andanalysis of our financial condition and results of operations is based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America(“GAAP”). The preparation of these financial statements requiresestimates and assumptions that affect the reported amounts of assets andliabilities, revenues and expenses, and related disclosures of contingent assetsand liabilities in the consolidated financial statements and accompanying notes.We base our estimates on historical experience and on other assumptions that webelieve to be reasonable under the circumstances. However, estimates inherentlyrelate to matters that are uncertain at the time the estimates are made, and arebased upon information presently available. Actual results may differsignificantly from these estimates under different assumptions, judgments, orconditions. 

***Revenue Recognition***

          We have adopted the*SEC Staff Accounting Bulletin (SAB) No. 101 — RevenueRecognition*, which defines that revenue is both earned and realizable whenthe following four conditions are met: pervasive evidence of an arrangementexists; the selling price is fixed or determinable; delivery or performance hasoccurred; and collectibility is reasonably assured.

          Per *SEC StaffAccounting Bulletin (SAB) No. 104*, which further clarifiesSAB No. 101, if merchandise is shipped to our customers F.O.B.shipping point, title is considered to have transferred to the customer at thetime the merchandise is delivered to the carrier. Our policy is to ship F.O.B.shipping point from our distribution center, third party warehouse andfulfillment center and drop ship locations, and therefore we recognize revenueat time of shipment. 

          We have also adopted*EITF 99-19, Reporting Revenue Gross as a Principal versus Net as anAgent*, as our formal guidelines for the recognition of revenue in ourconsolidated financial statements. All sales are completed through us andliability for product purchases is assumed by us. Therefore, we recognize thegross sales price as revenue. 

          Return allowances,which reduce gross sales, are estimated using historical experience. 

          The majority of oursales are processed through credit cards, and accounts receivable are composedprimarily of amounts due from financial institutions for credit card sales. Wedo not maintain an allowance for doubtful accounts because payment is typicallyreceived one to two business days after the sale is completed. 

36

***Inventory***

          Inventory isaccounted for using the first-in first-out (“FIFO”) method, and isvalued at the lower of cost or market value. This valuation requires us to makejudgments, based on currently available information, about the likely method ofdisposition, such as through sales to individual customers, returns to productvendors, or liquidations, and expected recoverable values of each method ofdisposition. Based on this evaluation, we adjust the carrying amount of ourinventories to the lower of cost or market value. 

          As of December 31,2006, the Company had a reserve for slow moving and obsolete inventory amountingto $49,000. No inventory reserves were recorded as of December 31, 2005. Formost of our operating history, we have relied on drop ship arrangements andfulfillment partners to ship the majority of our sales orders, which minimizesour inventory levels and associated risks. Since 2004, we have increased theamount of our warehouse inventory to support a higher level of in-housefulfillment. The increased inventory levels are largely comprised of productsthat have a proven sales track record and a low risk of near-term obsolescence.However, with the recent emergence of this trend toward greater in-housefulfillment and increased inventory levels, the risk of inventory obsolescencehas increased and there may be a need to recognize a reserve for obsolescence inthe future. 

***Goodwill*** 

          SFAS No. 141,*Business Combinations*, requires that all business combinations beaccounted for using the purchase method of accounting and that certainintangible assets acquired in a business combination be recognized as assetsseparate from goodwill. Goodwill is not subject to amortization and is testedfor impairment annually or more frequently if events or changes in circumstancesindicate that the asset may be impaired in accordance with SFAS No. 142,*Goodwill and Other Intangible Assets.*  The impairment test consistsof a comparison of the fair value of the reporting unit with its carryingamount.  If the carrying amount of the reporting unit exceeds its fairvalue, then an analysis will be performed to compare the implied fair value withthe carrying amount of goodwill. An impairment loss would be recognized in anamount equal to the difference. Fair value is generally based upon future cashflows discounted at a rate that reflects the risk involved or market-basedcomparables. After an impairment loss is recognized, the adjusted carryingamount of goodwill becomes its new accounting basis. 

***Valuation of Deferred Tax Assets***

          We account forincome taxes pursuant to SFAS No. 109,*Accounting for Income Taxes,*which requires that deferred tax assets be evaluated for future realizationand reduced by a valuation allowance to the extent we believe a portion will notbe realized.  We consider many factors when assessing the likelihood offuture realization of our deferred tax assets, including our history ofoperating losses, expectations of future taxable income, and the carry-forwardperiods available to us for tax reporting purposes. Significant managementjudgment is required in evaluating these factors and in determining the amountof the valuation allowance to be recorded against our net deferred taxassets.  For all periods presented the valuation allowance equals the totalof our deferred tax assets due primarily to our history of operating losses anduncertainties related to expectations of future taxable income.  Theuncertainties relating to the valuation of our deferred tax assets aresignificant, and it is very difficult to predict when, if ever, our assessmentmay conclude that some or all of our deferred tax assets are realizable. In theevent that actual results differ from these estimates and judgments, or weadjust these estimates in future periods, we may need to change the valuationallowance, which could materially impact our financial position and results ofoperations. 

***Stock-based Compensation***

          SFAS No. 123R,*Share-Based Payment,* is a revision of SFAS No. 123,*Accounting for Stock-Based Compensation*, and supersedes AccountingPrinciples Board Opinion (“APB”) No. 25, *Accounting for StockIssued to Employees.*Effective January 1, 2006, the Company adopted therecognition and reporting requirements of SFAS No. 123R, and thecorresponding recognition of compensation expense is included in ourconsolidated financial statements for 2006. 

37

          Prior to January 1,2006, we applied APB No. 25 and related interpretations in accounting forstock-based transactions with employees and complied with the disclosurerequirements of SFAS No. 123 and No. 148.  SFAS No. 148,*Accounting for Stock-Based Compensation—Transition andDisclosure—an amendment of FASB Statement No. 123*, amended SFAS No. 123to provide alternative methods of transition for a voluntary change to the fairvalue based method of accounting for stock-based employee compensation. Inaddition, this Statement amended the disclosure requirements of SFAS No. 123 torequire prominent disclosures in both annual and interim financial statementsabout the method of accounting for stock-based employee compensation and theeffect of the method used on reported results. 

**Results of Operations**

          The following tablepresents our historical operating results for the periods indicated as apercentage of net sales: 

 

 

**Year Ended   December 31,**

 

 

 

 

 

 

**2006**

 

**2005**

 

**2004**

 

 

 

 

 

 

Net sales

 

 

100.0

%

 

100.0

%

 

100.0

%

Cost of goods sold

 

 

71.4

 

 

73.5

 

 

74.2

 

 

 

 

 

 

Gross profit

 

 

28.6

 

 

26.5

 

 

25.8

 

Operating expenses

 

 

40.9

 

 

29.2

 

 

24.2

 

 

 

 

 

 

Operating income (loss)

 

 

(12.3

)

 

(2.7

)

 

1.5

 

Other income (expense)

 

 

(1.3

)

 

0.8

 

 

0.0

 

Gain on debt extinguishment

 

 

4.2

 

 

0.0

 

 

0.0

 

 

 

 

 

 

Income (loss) before income   taxes

 

 

(9.4

)

 

(2.0

)

 

1.5

 

Provision (benefit) for   income taxes

 

 

(0.0

)

 

0.1

 

 

0.0

 

 

 

 

 

 

Net income (loss)

 

 

(9.4

)

 

(2.1

)

 

1.5

 

 

 

 

 

 

The above table may not sum due to rounding.

          The followingdescribes certain line items set forth in our consolidated statements ofoperations:

          *Grosssales.*  Our gross sales relate to baby, toddler, maternity, bedding andfurniture products sold through our websites, BabyUniverse.com,DreamtimeBaby.com, PoshTots.com and PoshLiving.com*.*The increase in grosssales from period to period is attributable to factors such as changes in oursales conversion rates, expanded product offerings, acquisitions of theDreamTimeBaby.com and PoshTots.com businesses, and the level of our advertisingand commission spending. Our sales increases are a reflection primarily ofincreases in the volume of products shipped, rather than price increases or theintroduction of new products. Shipping charges billed to customers are alsoincluded in gross sales. 

          *Discounts andreturns.*Those products that are returned from customers, or that arediscounted, are charged to discounts and returns, which are subtracted fromgross sales to arrive at net sales. 

          *Gross profit.*Our gross profit consists of gross sales, less discounts and returns andcost of goods sold. Our cost of goods sold consists of the cost of products soldto customers, inbound and outbound shipping costs and insurance on shipments.Our gross margin consists of gross profit divided by net sales. 

          *Operatingexpenses. *Our major operating expenses consist primarily ofadvertising, including commissions related to our affiliate marketing program,salary and related benefit costs for our employees, and general andadministrative expenses, including credit card fees and public companyexpenses.

          *Other income(expense). *Other income (expense) generally includes interest incomeand interest expense.

38

***Comparison of Year ended December 31, 2006  to Year endedDecember 31, 2005***

          The operationaldifficulties and their impact on the Company’s performance during 2006relating to the restructuring, reorganization and business integrationinitiatives undertaken by the Company are described above in Management’sDiscussion and Analysis of Financial Condition and Results of Operations –Recent Developments – Operational Restructuring and Reorganization, and– Current Operating Environment. 

          *Grosssales. *Gross sales increased 54.3% to $37.8 million for 2006 from$24.5 million last year.  The most significant driver of our increasein gross sales was the consolidation of operating results of the businesses ofDreamtimeBaby and PoshTots as of their September 13, 2005 and January 13, 2006acquisition dates, respectively. 

          *Discounts andreturns.*Discounts and returns amounted to $2.21 million, or 5.9% of grosssales for 2006, compared to $.81 million, or 3.3% of gross sales, for 2005.

          *Gross profit.*Gross profit increased 61.9% to $10.2 million for 2006 from $6.3 million for2005, and the increase primarily reflected the inclusion in 2006 of theoperating results of the DreamtimeBaby and PoshTots acquisitions. Theconsolidated gross margin increased to 28.5% for 2006 compared to 26.5% for2005.  Most of the consolidated gross margin improvement reflected thebenefit of the higher gross margin for the PoshTots brand, which exceeded 43%during 2006.  Our gross profit in the fourth quarter of 2006 was negatively impacted by certain factors related to the company’s strategic alternatives process, including the suspension ofcertain cost saving and operating intiatives  and high turnover ofkey operations and management personnel.

          *Operatingexpenses.*Operating expenses increased to $14.6 million for 2006 from $6.9million for 2005.  As a percentage of net sales, operating expenses were40.9 % for 2006 compared to 29.2 % for 2005.  The increase in operatingexpenses as a percentage of net sales was primarily attributable to: 

 

•

restructuring expenses during the first and second quarter of 2006 ofapproximately $506,000 to open our new distribution center and to integrate therecent acquisitions of the businesses of DreamtimeBaby and PoshTots with theBabyUniverse e-commerce business,

 

 

 

 

•

increased management salaries and technology-related depreciation expenses toexpand the infrastructure to support our acquisition strategy, as well as thedevelopment of our content and new media business,

 

 

 

 

•

increased general and administrative expenses incurred as a result of ourbecoming a public company in August 2005, including increased expenses forinsurance, legal, accounting and investor relations,

 

 

 

 

•

increased rent expense associated with the newly-developed Las Vegasdistribution center, as well as office relocations and expansions for thePoshTots headquarters in Richmond, Virginia and the Company’s headquartersin Jupiter, Florida, and

 

 

 

 

•

share-based compensation of  $232,048, resulting from the adoption of SFASNo. 123(R), *Share-Based Payment*, effective January 1, 2006.

          Advertising expensesimproved to 13.1 % of net sales for 2006 from 14.7 % for 2005.  Theadvertising expense improvement, as a percentage of net sales, was due to thesubstantially lower rate of advertising spending inherent in the DreamtimeBabyand PoshTots business models.

          *Other income(expense).* Other income, net, was $1,047,688 for 2006 compared to$177,823 for 2005.  Included in 2006 was a $1.5 million gain fromextinguishment of debt (See Note 8 to our Consolidated Financial Statements– Notes and Capital Lease Payables), as well as $155,701 of interest incomeearned on cash and cash equivalents.  These amounts were partially offsetby $608,013 of interest expense for 2006.

          *Incometaxes. *There was no provision for income taxes for 2006 or 2005. We had net operating loss carry forwards of approximately $6,900,000 atDecember 31, 2006, which will expire in various years through 2026. Werecorded a valuation allowance which fully offset the deferred tax benefit ofthe net operating loss carry forwards. 

          *Netloss.*  The net loss for 2006 was $3,343,700, or ($.62) per dilutedshare, compared to a net loss of $492,297, or ($.13) per diluted share for2005.  

39

***Comparison of Year ended December 31, 2005 to Year endedDecember 31, 2004***

          *Gross sales.*Gross sales increased 66% to $24.5 million for 2005 from$14.8 million for 2004.  The increase in gross sales was due toseveral factors: increased web traffic resulting from higher levels ofadvertising to promote the BabyUniverse brand, an increase in our salesconversion rate and certain free shipping promotions.  Our gross sales alsoincreased due to the consolidation of DreamtimeBaby gross sales since September13, 2005.  We also believe that one of the key drivers of the growth of oursales is was the transition of purchases made by women through traditionaloutlets to purchases made over the Internet. This trend has been reported bymarket research firms including eMarketer, Inc. and Forrester Research.

          *Discounts andreturns.*Discounts and returns decreased to 3.4% of net sales for 2005 from3.6% of net sales for 2004. 

          *Gross profit.*Gross profit increased 70.5% to $6.3 million for 2005 from $3.7 millionfor 2004. The increase in gross profit resulted from higher sales volumes. Grossmargin improved to 26.5% for 2005 compared to 25.8% for 2004. In fact, our grossmargin consistently improved every quarter in 2005, from a low of 23.0% in thefirst quarter to 30.1% in the fourth quarter. 

          Several importantfactors led to our improved gross margin performance throughout 2005. First  during August, our largest vendor adopted a minimum Internet pricingpolicy, and this contributed to gross margin improvement for the last twoquarters of the year.  Secondly, our overall shipping costs benefited fromeconomies of scale, despite higher gasoline surcharges.  The third factorcontributing to our gross margin improvement was the increasing percentage ofour sales that were shipped from inventory, rather than from dropshippers.  This percentage stood at about 50% as of December 2005 and grewconsistently since the beginning of 2005, when it was approximately 30%. The final factor positively affecting our overall gross margin in 2005 was theconsolidated benefit of higher gross margins in the range of 35% from theDreamtimeBaby acquisition. 

          *Operatingexpenses.*Operating expenses more than doubled to $6.9 million for 2005from $3.5 million for 2004.  As a percentage of net sales, operatingexpenses were 29.3% for 2005 compared to 24.3% for 2004.  The increase inoperating expenses as a percentage of net sales was almost entirely the resultof additional infrastructure costs to support our acquisition strategy, as wellas substantially higher general and administrative expenses incurred as a resultof our becoming a public company in August 2005.

          To a lesser extent,the increase in operating expenses was due to increased advertising andcommission expenses, which, as a percentage of sales, increased to 14.7% for2005 from 13.5% for 2004.  These expenses were incurred in an effort tocontinue to rapidly build awareness of the BabyUniverse brand, drive net salesgrowth and gain market share as rapidly as possible in the highly fragmented andcompetitive market segment for the online sales of baby-related products.

          *Other income(expense).* Other income, net, was $177,823 for 2005 compared to $1,204for 2004, due to interest income earned on the net proceeds of theCompany’s initial public offering of common stock in August2005.

          *Income taxes.*We had net operating loss carry forwards of 3,004,520 at December 31,2005 which will expire in various years through 2025. Our net operating losscarry forwards at December 31, 2004 were $2,229,588.  We recorded avaluation allowance which fully offset the deferred tax benefit of the netoperating loss carry forwards for 2005 and 2004. 

          *Net income(loss).*   The net loss for the full year 2005 was ($492,297), or($0.13) per diluted share, compared to net income of $221,061, or $0.07 perdiluted share for 2004.  The most significant factor in this 2005 net losswas the aapproximately $591,000 investment in acquisition infrastructure andpublic company costs that we incurred during 2005. 

40

**Effect of Recent Accounting Pronouncements**

          In February 2006,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 155,*Accounting for Certain Hybrid Financial Instruments—an amendment of FASBStatements No. 133 and 140.*  This Statement amends FASB Statements No.133, *Accounting for Derivative Instruments and Hedging Activities,* andNo. 140, *Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities.*  This Statement resolves issuesaddressed in Statement 133 Implementation Issue No. D1, “Application ofStatement 133 to Beneficial Interests in Securitized FinancialAssets.”  This Statement:

 

a.

Permits fair value remeasurement for any hybrid financial instrument thatcontains an embedded derivative that otherwise would requirebifurcation.

 

 

 

 

b.

Clarifies which interest-only strips and principal-only strips are not subjectto the requirements of Statement 133.

 

 

 

 

c.

Establishes a requirement to evaluate interests in securitized financial assetsto identify interests that are freestanding derivatives or that are hybridfinancial instruments that contain an embedded derivative requiringbifurcation.

 

 

 

 

d.

Clarifies that concentrations of credit risk in the form of subordination arenot embedded derivatives.

 

 

 

 

e.

Amends Statement 140 to eliminate the prohibition on a qualifyingspecial-purpose entity from holding a derivative financial instrument thatpertains to a beneficial interest other than another derivative financialinstrument.

          This Statement iseffective for all financial instruments acquired or issued after the beginningof an entity’s first fiscal year that begins after September 15,2006.  Management does not expect adoption of SFAS No. 155 to have amaterial impact, if any, on the Company’s financial position or results ofoperations. 

          In March 2006, theFASB issued SFAS No. 156, *Accounting for Servicing of Financial Assets anamendment of FASB Statement No. 140*.  This Statement amends FASBStatement No. 140, *Accounting for Transfers and Servicing of Financial Assetsand Extinguishments of Liabilities*, with respect to the accounting forseparately recognized servicing assets and servicing liabilities.  ThisStatement:

 

a.

Requires an entity to recognize a servicing asset or servicing liability eachtime it undertakes an obligation to service a financial asset by entering into aservicing contract.

 

 

 

 

b.

Requires all separately recognized servicing assets and servicing liabilities tobe initially measured at fair value, if practicable.

 

 

 

 

c.

Permits an entity to choose either the amortization method or the fair valuemeasurement method for subsequent measurement for each class of separatelyrecognized servicing assets and liabilities.

 

 

 

 

d.

At its initial adoption, permits a one-time reclassification ofavailable-for-sale securities to trading securities by entities with recognizedservicing rights, without calling into question the treatment of otheravailable-for-sale securities under Statement No. 115.

 

 

 

 

e.

Requires separate presentation of servicing assets and liabilities subsequentlymeasured at fair value in the statement of financial position and additionaldisclosures.

          An entity shouldadopt this Statement as of the beginning of its first fiscal year that beginsafter September 15, 2006.  Earlier adoption is permitted as of thebeginning of an entity’s fiscal year, provided the entity has not yetissued financial statements, including interim financial statements, for anyperiod of that fiscal year. The effective date of this Statement is the date anentity adopts the requirements of this Statement.  The adoption of thisStatement is not expected to have a material impact on the Company’sconsolidated financial statements. 

          In June 2006, theEmerging Issues Task Force (“EITF”) issued EITF 06-3, “How TaxesCollected from Customers and Remitted to Governmental Authorities Should BePresented in the Income Statement (That is, Gross versus Net Presentation)”to clarify diversity in practice on the presentation of different types of taxesin the financial statements. The Task Force concluded that, for taxes within thescope of the issue, a company may adopt a policy of presenting taxes eithergross within revenue or net. That is, it may include charges to customers fortaxes within revenues and the charge for the taxes from the taxing authoritywithin cost of sales, or, alternatively, it may net the charge to the customerand the charge from the taxing authority. If taxes subject to EITF 06-3 aresignificant, a company is required to disclose its accounting policy forpresenting taxes and the amounts of such taxes that are recognized on a grossbasis. The guidance in this consensus is effective for the first interimreporting period beginning after December 15, 2006 (the first quarter of ourfiscal year 2007). We do not expect the adoption of EITF 06-3 will have amaterial impact on our consolidated results of operations, financial position orcash flow.

41

          In July 2006, theFASB issued Interpretation No. 48, *Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109.*  ThisInterpretation clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with FASBStatement No. 109, *Accounting for Income Taxes.*  This Interpretationprescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return.  This Interpretation also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition.  This Interpretation is effective forfiscal years beginning after December 15, 2006.  Earlier application of theprovisions of this Interpretation is encouraged if the enterprise has not yetissued financial statements, including interim financial statements, in theperiod this Interpretation is adopted.  Management does not expect adoptionof Interpretation No. 48 to have a material impact, if any, on theCompany’s consolidated financial position or results of operations.

          In September 2006,the FASB issued SFAS No. 157, *Fair Value Measurements*, which defines thefair value, establishes a framework for measuring fair value and expandsdisclosures about fair value measurements. This Statement is effective forfinancial statements issued for fiscal years beginning after November 15, 2007,and interim periods within those fiscal years. Early adoption is encouraged,provided that a company has not yet issued financial statements for that fiscalyear, including any financial statements for an interim period within thatfiscal year. We are currently evaluating the impact SFAS 157 may have on ourconsolidated financial condition or results of operations.

          In September 2006,the United States Securities and Exchange Commission (SEC) issued StaffAccounting Bulletin No. 108, *Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements* (“SAB 108”). This SAB provides guidance on theconsideration of the effects of prior year misstatements in quantifying currentyear misstatements for the purpose of a materiality assessment. SAB 108establishes an approach that requires quantification of financial statementerrors based on the effects of each of the company’s balance sheet andstatement of operations and the related financial statement disclosures. The SABpermits existing public companies to record the cumulative effect of initiallyapplying this approach in the first year ending after November 15, 2006 byrecording the necessary correcting adjustments to the carrying values of assetsand liabilities as of the beginning of that year with the offsetting adjustmentrecorded to the opening balance of retained earnings. Additionally, the use ofthe cumulative effect transition method requires detailed disclosure of thenature and amount of each individual error being corrected through thecumulative adjustment and how and when it arose. We are currently evaluating theimpact SAB 108 may have on our consolidated financial condition or results ofoperations. 

          In September 2006,the FASB issued SFAS No. 158, *Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans—an amendment of FASB Statements No.87, 88, 106, and 132(R).* This Statement improves financial reporting byrequiring an employer to recognize the overfunded or underfunded status of adefined benefit postretirement plan (other than a multiemployer plan) as anasset or liability in its statement of financial position and to recognizechanges in that funded status in the year in which the changes occur throughcomprehensive income of a business entity or changes in unrestricted net assetsof a not-for-profit organization. This Statement also improves financialreporting by requiring an employer to measure the funded status of a plan as ofthe date of its year-end statement of financial position, with limitedexceptions.  An employer with publicly traded equity securities is requiredto initially recognize the funded status of a defined benefit postretirementplan and to provide the required disclosures as of the end of the fiscal yearending after December 15, 2006.  Earlier application of the recognition ormeasurement date provisions is encouraged; however, early application must befor all of an employer’s benefit plans. Retrospective application of thisStatement is not permitted.  Management does not expect adoption of SFASNo. 158 to have a material impact, if any, on the Company’s consolidatedfinancial position or results of operations.  

**Liquidity and Capital Resources**

          *Sources of fundsand Liquidity. *Since inception, we have funded our operations throughthe sale of equity securities and convertible indebtedness, and cash generatedfrom operations.  The significant components of our working capital areinventory and liquid assets such as cash and cash equivalents.  As ofDecember 31, 2005, our working capital was $8.7 million, whichresulted primarily from the proceeds of our initial public offering of commonstock in August 2005.  As of December 31, 2006 we had negative workingcapital of approximately $44,000. The decline in working capital is primarilyattributable to investing activities, described below under “*Uses offunds”*.

42

          Net cash provided byfinancing activities for 2006 was approximately $4.0 million, and was primarilyattributable to the debt and equity transactions described below.  Net cashprovided by financing activities for 2005 was $16.5 million, and was primarilyattributable to BabyUniverse’s initial public offering of common stock inAugust, 2005.  

          During 2006, wecompleted the following debt and equity transactions to refinance existing debtand to raise funds for general corporate purposes:

•

On July 11, 2006, BabyUniverse completed a $5.0 million debt financingtransaction with Hercules Technology Growth Capital, Inc. (NASDAQ: HTGC), aleading specialty finance company providing venture capital and privateequity-backed technology and life science companies with debt and equity growthcapital. Proceeds from the financing were used primarily to refinanceBabyUniverse’s existing debt. (See Note 8 to our Consolidated FinancialStatements  – Notes and Capital Lease Payables)

 

 

•

On September 22, 2006, BabyUniverse closed on $2 million in new equityfinancing.  The equity financing was provided by affiliates of WyndcrestHoldings, LLC, a company controlled by our Chief Executive Officer John C.Textor.  In connection with the financing, the Company received aggregateproceeds of approximately $2 million, based on the issuance of 263,852 shares ofcommon stock priced at $7.58 per share, a 7.5% premium to the closing price onSeptember 22, 2006.  These funds are to be used for general corporatepurposes. (See Note 17 to our Consolidated Financial Statements –Transactions With Related Parties)

 

 

•

On December 29, 2006, BabyUniverse entered into a Loan Agreement with LydianPrivate Bank, pursuant to which Lydian Private Bank provided a term loan of$2,000,000 to the Company (the “Lydian Loan”), evidenced by aPromissory Note in that principal amount dated December 29, 2006. The Lydian Loanbears interest at a floating rate of interest equal to the base rate oncorporate loans posted by at least 75% of the nation’s largest banks, knownas the “Wall Street Journal Prime,” which interest is payable monthlybeginning on February 1, 2007. The maturity date of the Lydian Loan is July 1,2008, at which time all outstanding principal and accrued but unpaid interestthereunder must be repaid to Lydian Private Bank. (See Note 17 to ourConsolidated Financial Statements – Transactions with RelatedParties)

          *Uses offunds. *Net cash used in operating activities for 2006 was $2,947,671,compared to net cash used by operating activities of $22,312 for 2005.  Theincrease in cash used in operating activities was primarily due to the net lossin 2006 of $3,343,700 including a non-cash gain of $1,500,000 on extinguishmentof debt, compared to a net loss in 2005 of $492,297.  

          Net cash used ininvesting activities for 2006 was approximately $7.5 million and was primarilyrelated to the acquisition of PoshTots ($6.0 million), and to a lesser extent,capital expenditures ($1.6 million) associated with our business restructuringand integration, as well as enhancements to our technology systeminfrastructure.

          On June 23, 2006,the Company’s credit card merchant agreement for its DreamtimeBaby businesswas unilaterally terminated by the processing company and funding bank, due to arecent increase in the volume of customer refunds and chargebacks. Theunilateral termination of the merchant agreement was not confirmed to theCompany until July 18, 2006, despite repeated attempts by the Company to clarifythe then-existing situation.  When confirmation of the termination wasverbally received on July 18, 2006, the Company established a new credit cardprocessing and funding account for its DreamtimeBaby business through another ofits existing credit card processing agreements.  In conjunction withtermination of the agreement, and pursuant to rights based on its solediscretion, the funding bank unilaterally established a reserve account bywithholding funding to the Company of credit card proceeds from June 23 untilJuly 18, 2006.  The resulting reserve account balance was $371,000. TheCompany negotiated the release of $270,000 of this reserve in December 2006 andanother $90,000 was released to the Company in February 2007. 

43

          The proceeds fromour initial public offering in August 2005 had been sufficient to fund ouracquisitions and operational requirements through early 2006. The Company thensecured the additional debt and equity financings described above in order tofund a repayment of its debt, as well as to provide additional working capitalfor general corporate purposes.  We are currently evaluating a number offunding alternatives.  It is possible that we could be required, or couldelect, to seek additional funding through an equity or debt financing in thefuture, in order to fund strategic alternatives or our working capital oroperational requirements, or to refinance our existing indebtedness. Inaddition, pursuant to the terms of the Merger Agreement, it is a condition tothe closing of the Merger that the Company’s then existing indebtedness berepaid from the proceeds of an equity financing to be conducted by the Companyafter the date on which the Merger Agreement was executed. Any such futurefinancing may not be available on terms acceptable to us, or at all. 

          As of December31, 2006, we had no material commitments for capitalexpenditures.

**Contractual Obligations**

          The following tablesummarizes our contractual obligations as of December 31, 2006 and theexpected effect on liquidity and cash flows: 

          Payments due byperiod are as follows:

 

 

**Total**

 

**2007**

 

**2008   through   2010**

 

**2011   through   2012**

 

**After 2012**

 

 

 

 

 

 

 

 

Operating leases

 

$

3,234,122

 

$

656,290

 

$

1,802,935

 

$

774,897

 

 

-0-

 

Capital leases

 

 

27,960

 

 

7,558

 

 

13,713

 

 

6,689

 

 

-0-

 

Notes Payable

 

 

7,000,000

 

 

836,062

 

 

6,163,938

 

 

-0-

 

 

-0-

 

**Off-Balance Sheet Arrangements**

          We do not have orengage in any off-balance sheet arrangements. 

**Impact of Inflation**

          The effect ofinflation and changing prices on our operations was not significant during theperiods presented. 

**Outstanding Stock Options**

          As of December 31,2006, we had 236,248 options to purchase common shares outstanding, of which113,082 are fully vested.  The vested and unvested options have weightedaverage exercise prices of $4.22 and $8.68, respectively. 

          On October 1,2004, we granted options to purchase 156,372 shares of common stock at anexercise price of $1.27 per share. We based the fair market valuation at thattime on the Market Multiple and Discounted Cash Flow Approaches, coupled withthe fact that we had not yet become profitable on a full year basis. While webelieved that our business plan for organic growth was sound, we recognized thatour opportunities to generate liquidity were relatively scarce and we had notyet been successful in attracting a credible investment bank in the pursuit ofstrategic alternatives. Our valuation was later confirmed by an independentappraisal that was obtained retrospectively in the second quarter of 2005.

          On January 18,2005, we granted additional options to purchase 52,124 shares of common stock atan exercise price of $6.25 per share. The $6.25 exercise price, whichrepresented a significant increase from the October 1, 2004 fair marketvaluation, was based on the Market Multiple and Discounted Cash Flow Approaches,coupled with several significant developments. First, we had become profitableon a full-year basis for the first time in 2004. Second, we had adopted anexpanded business plan, which would use strategic acquisitions to complement ourorganic growth initiatives. Third, our board of directors and management teamhad been expanded and strengthened to include a diverse group of businessleaders who had significant experience in the financial, technology and retailsectors, with a particular emphasis on working for and with companies engaged insubstantial acquisitions programs. These developments resulted in an increasedinterest from investment banks seeking to represent us in pursuing strategicalternatives and caused us to significantly adjust the fair market valuation ofour company. Management chose not to seek an independent appraisal at this time,due to the referenced significant factors and preliminary discussions withinvestment banks regarding the value of our company.

44

          On January13, 2006, we granted options to purchase 50,000 shares of our common stock toofficers of Posh Tots, LLC in connection with the Company’s purchase of theassets of Posh Tots, LLC.   These options bore an exercise price of$8.10 per share, the closing price of our common stock on the American StockExchange on the date of the grant, vested over a two year period and expireafter 25 months.  Subsequent to January 13, 2006, options to purchase30,000 of these shares were cancelled in connection with one such officer’stermination of employment with the Company.

          On January13, 2006, we granted options to purchase 75,000 shares of our common stock toemployees of Posh Tots, LLC in connection with the Company’s purchase of theassets of Posh Tots, LLC.   These options bore an exercise priceof  $8.10 per share, the closing price of our common stock on the AmericanStock Exchange on the date of the grant, vested over a three year period andexpire after 37 months.  Subsequent to January 13, 2006, options topurchase 15,000 of these shares were cancelled in connection with threesuch employees’ termination of employment with theCompany.

          On April 3, 2006,the Company granted options to purchase 50,000 shares of our common stock to akey employee involved in the development and implementation of the BabyTV newmedia concept.  These options bear an exercise price of $9.86 per share,the closing price of the common stock on The Nasdaq Capital Market on the dateof the grant, vest quarterly over a three year period and expire after 36months.  

          On November 16,2006, the Company granted options to purchase 2,000 shares of our common stock,to an employee.  These options bear an exercise price of $6.84 per share,the closing price of the common stock on The Nasdaq Capital Market on the dateof the grant, 25% of which vested immediately, with the remainder vesting overtwo years.  These options expire in 25 months.

          On December 11,2006, the Company granted 25,000 restricted shares of our common  stock toan employee. These restricted share vest over a four year period.

**ITEM 7A.**

**QUANTITATIVE   AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

          The primaryobjective of our investment activities is to preserve principal while at thesame time maximizing yields without significantly increasing risk.  Ourcash and cash equivalents balance as of December 31, 2006 was held in moneymarket accounts or invested in investment grade commercial paper with maturitiesless than 90 days. 

**ITEM 8.**

**FINANCIAL   STATEMENTS AND SUPPLEMENTARY DATA**

          Financial statementsand supplementary data for the Company appear on pages F-1 through F-30following Item 15 of this Report and are incorporated herein byreference.

**ITEM 9.**

**CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE**

          None.

**ITEM 9A.**

**CONTROLS   AND PROCEDURES**

          We maintaindisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed in our periodic reports filed pursuant to theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedwithin the time periods specified by the rules and forms of the Securities andExchange Commission (“SEC”) and that such information is accumulatedand communicated to our management, including our chief executive officer andchief financial officer, as appropriate, to allow for timely decisions regardingrequired disclosure. In designing and evaluating the disclosure controls andprocedures, management recognizes that any controls and procedures, no matterhow well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives, and management must apply its judgmentin evaluating the cost-benefit relationship of possible controls andprocedures.

45

          As required byRule 13a-15(b) of the Securities Exchange Act of 1934, we conducted anevaluation, under the supervision and with the participation of our management,including our chief executive officer and chief financial officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures as of the end of the period covered by this report. Based on theforegoing, our chief executive officer and chief financial officer concludedthat our disclosure controls and procedures were effective at the reasonableassurance level.

          In addition, therehas been no change in our internal controls over financial reporting during ourmost recent fiscal quarter that has materially affected, or is reasonably likelyto materially affect, our internal controls over financial reporting.

          Our management,including our chief executive officer and our chief financial officer, does notexpect that our disclosure controls and procedures or our internal control overfinancial reporting are or will be capable of preventing or detecting all errorsand all fraud. Any control system, no matter how well designed and operated, canprovide only reasonable, not absolute, assurance that the control system’sobjectives will be met. The design of a control system must reflect the factthat there are resource constraints and the benefits of controls must beconsidered relative to their costs. Further, because of the inherent limitationsin all control systems, no evaluation of controls can provide absolute assurancethat misstatements due to error or fraud will not occur or that all controlissues and instances of fraud, if any, within the Company have been detected.These inherent limitations include the realities that judgments indecision-making can be faulty and that breakdowns can occur because of simpleerror or mistake. Controls can also be circumvented by the individual acts ofsome persons, by collusion of two or more people, or by management override ofthe controls. The design of any system of controls is based in part on certainassumptions about the likelihood of future events, and there can be no assurancethat any design will succeed in achieving its stated goals under all potentialfuture conditions.

**ITEM 9B.**

**OTHER   INFORMATION**

          None.

**PART III**

**ITEM 10.**

**DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE**

          Our Board ofDirectors currently consists of seven directors, divided into three classes withmembers of each class of directors serving for staggered three-year terms. Our current Board members and classifications are as follows:  

**Class I**

 

**Class II**

 

**Class III**

 

 

Curtis   S. Gimson

 

Carl   Stork

 

Stuart   Goffman

Bethel   G. Gottlieb

 

Jonathan   Teaford

 

John   Nichols

 

 

 

 

John   C. Textor

Terms for the Class I, II and III Directors expire at the annual meetings for2009, 2007 and 2008, respectively.

          John C. Textor, 41,has been Chairman of our Board of Directors since November 2002 and a member ofour Board of Directors since December 1999. Mr. Textor has served as ourChief Executive Officer since April 2005. He is also the Founder and Presidentof Wyndcrest Holdings, LLC, a Florida-based private holding company focused ontechnology-related opportunities in entertainment, telecommunications and theInternet, and its predecessor since 1997.

46

Earlier, Mr. Textor was employed in various merchant banking and investmentbanking capacities by Shearson Lehman Hutton and Paine Webber. Mr. Textorwas also a founding director of Lydian Trust Company, a diversified financialservices company. He is currently a director of Multicast Media Networks, Inc.,a global provider of Internet-based broadcast media. He was previously Chairmanof the Board of Sims Snowboards, a prominent global snowboard brand.Mr. Textor earned a B.A. degree in Economics at WesleyanUniversity.

          Carl Stork, 47,became a member of our Board of Directors in October 2004. Mr. Stork isPresident and Founder of Ciconia & Co, LLC, a private investment firmbased in Seattle, Washington. Mr. Stork is Chief Executive Officer of DigitalDomain, Inc., an award winning visual effects and digital media company inVenice, California. He is also a non-managing member of Wyndcrest Holdings, LLC.Prior to founding Ciconia, Mr. Stork had a long and varied career atMicrosoft Corporation from 1981 to 2002, serving in a variety of executivemanagement positions, including technical assistant to Bill Gates, GeneralManager of Windows 95/98 Development and General Manager of Hardware Strategyand Business Development. Mr. Stork served on the board of directors ofLydian Trust Company until March 2005, and currently serves on the board ofdirectors of Neomagic Corporation, a publicly traded company which developsapplication processors for hand held devices. Mr. Stork is a partner in theBaseball Club of Seattle, owner of the Seattle Mariners major league baseballteam. Mr. Stork earned an MBA degree at the University of Washington and aB.A. degree in Physics at Harvard University. 

          John Nichols, 55,became a member of our Board of Directors in January 2005. Mr. Nichols isChief Financial Officer, Secretary and Treasurer of Varsity Brands, Inc., amanufacturer and marketer of branded products and services for the educationalextracurricular market, including team sports and cheerleading. He also servedas Senior Vice President, Finance of Varsity Spirit Corporation, apublicly-traded predecessor of Varsity Brands, Inc., since July 1992 and ChiefFinancial Officer since April 1994. Mr. Nichols earned his B.B.A. degree inAccounting at the University of Memphis and a M.S.M. degree in Accounting atFlorida International University.

          Curtis S. Gimson,51, became a member of our Board of Directors in April 2005. Mr. Gimson hasbeen Senior Vice President of Arby’s Restaurant Group, Inc. since 1997, andserved as General Counsel of Arby’s Restaurant Group from 1997 until 2005.In 1984, he joined Triangle Industries, Inc., a public company controlled byNelson Peltz and Peter May, and has worked in various capacities for companiescontrolled by Messrs. Peltz and May for the past 22 years, including asAssociate General Counsel of Triangle 1984-89, Senior Vice President &General Counsel, Trian Group, L.P., 1989-93, Senior Vice President &Associate General Counsel of Triarc Companies, Inc., 1993-94, Senior VicePresident & General Counsel, Royal Crown Cola Co., 1994-97, and SeniorVice President & General Counsel of Arby’s since 1997.Mr. Gimson earned his B.A. degree at Princeton University and his J.D.degree at Cornell Law School.

          Bethel G. Gottlieb,38, became a member of our Board of Directors in June 2005. From 1995 to 2000,Ms. Gottlieb served in progressively senior merchandising management positionsfor May Department Stores and Federated Department Stores. While at FederatedDepartment Stores, Ms. Gottlieb was responsible for overseeing themerchandising strategy and product development for all store divisions. From2000 to the present, Ms. Gottlieb has remained at home caring for her youngchildren. Ms. Gottlieb earned a B.A. degree in Psychology from WesleyanUniversity and an M.B.A. degree from Harvard University Graduate School ofBusiness.

          Stuart Goffman, 40,was our interim Chief Financial Officer from October 2006 to December 2006, ourChief Operating Officer from January 2005 through October 2006 , our Presidentfrom October 2002 through January 2005, and a member of our Board of Directorssince October 1998. In June 2000, Mr. Goffman left BabyUniverse andco-founded and became the Chief Operating Officer and director of ChildU, Inc.,a distance learning company specializing in online education forgrades K-8. ChildU, Inc., was acquired by WRC Media, Inc. in May 2001.Mr. Goffman rejoined BabyUniverse in October 2002 and was our ChiefExecutive Officer from October 2002 to April 2005. Mr. Goffman was previouslyemployed by Grant Thornton in New York. Mr. Goffman is a Certified PublicAccountant (“CPA”) certified in the State of Georgia. He earned a B.S.degree in Accounting at the University of Florida. 

          Jonathan Teaford,33, has been our Executive Vice President since January 2005 and has been amember of our Board of Directors since December 2000. Mr. Teaford has beena partner with Wyndcrest Holdings, LLC, since March 2002. Prior to joiningWyndcrest’s predecessor in January 1998, Mr. Teaford was employed byGE Capital Services, a subsidiary of General Electric. Mr. Teaford earned aB.A. in Economics at Hamilton College.

47

**Board of Advisors**

          In addition to ourBoard of Directors, we have a Board of Advisors. The Board of Advisor’spurpose is solely to provide non-binding advice and counsel to our Board ofDirectors. The current members of our Board of Advisors are as follows:

          Michael Bay          Kenneth Goore          DanMarino

          MichaelBay became a member of our Board of Advisors in October 2004 and has served as aninformal advisor to the company since October 2002. Mr. Bay is a principalof Bay Films, Inc. Mr. Bay has produced and directed the major motionpictures *Armageddon, Pearl Harbor*, and *The Island.*  He alsodirected *Bad Boys, The Rock*, and *Bad Boys II*. Through hisproduction company, Platinum Dunes Productions, he also produced *The TexasChainsaw Massacre*(2003) and *The Amityville Horror*(2005). Hehas filmed television commercials for many major advertisers including Nike,Coca-Cola, Levi’s, and for the Got Milk campaign. He has also filmed awardwinning music videos for artists including Aerosmith, Tina Turner, Meatloaf andDivinyls. Mr. Bay earned a B.A. degree in English and Film at WesleyanUniversity. 

          Kenneth Goore becamea member of our Board of Advisors in April 2005. In 1992, Mr. Gooreco-founded Goore’s For Babies to Teens, which today is one of the largestspecialty baby and children’s retail stores in the western United States.Mr. Goore earned a B.S. degree in Marketing and Finance at the Universityof Akron. 

          Dan Marino became amember of our Board of Advisors in October 2004. In April 2000, Mr. Marinoannounced his retirement from professional football after 17 consecutive seasonswith the Miami Dolphins of the National Football League. He has sinceestablished himself as a leading television sports commentator through his workwith the CBS *NFL Today*show and HBO’s *Inside the NFL*. Hisongoing work for the community is centered on the Dan Marino Foundation forchildren’s charities of South Florida. Mr. Marino earned a B.A. degreein Communications at the University of Pittsburgh.

**Compensation of Directors**

          We pay eachnon-employee director an annual retainer of $5,000. We pay each non-employeedirector $500 for each committee meeting attended. We also pay certainreasonable expenses incurred by our directors and members of our Board ofAdvisors. 

           Non-employeedirectors and Board of Advisors members may be granted restricted stock oroptions pursuant to the BabyUniverse 2005 Stock Incentive Plan. Our non-employeedirectors will be eligible to receive restricted stock or options to the extentgranted by our Compensation Committee. We may, in our discretion, grantadditional restricted stock or options and other equity awards to ournon-employee directors and members of our Board of Advisors from time to time.

**Independence of the Board**

          The Board ofDirectors has determined that the following four individuals of its sevenmembers are independent as defined under the federal securities laws, includingRule 10A-3(b)(i) under the Securities Exchange Act of 1934, and the NasdaqMarketplace Rules:  Mr. Gimson, Ms. Gottlieb, Mr. Nichols and Mr.Stork.  

**Committees and Meetings of the Board of Directors**

          The Board ofDirectors held nine meetings, including four regularly scheduled meetings andfive special meetings, during the year ended December 31, 2006.  It is thepolicy of the Board of Directors to encourage attendance at Board and committeemeetings. Each director attended at least 75% or more of the aggregate number ofmeetings held by the Board of Directors and the committees on which he or sheserved. Our Board of Directors has three standing committees: the AuditCommittee, the Compensation Committee and the Nominating Committee. 

48

          *AuditCommittee*.  The Audit Committee presently consists of Messrs. Gimson,Stork, and Nichols, who serves as chairman. The Audit Committee is responsiblefor reviewing and monitoring our financial statements and internal accountingprocedures, recommending the selection of independent auditors by our Board ofDirectors, evaluating the scope of the annual audit, reviewing audit results,consulting with management and our independent auditor prior to presentation offinancial statements to shareholders and, as appropriate, initiating inquiriesinto aspects of our internal accounting controls and financial affairs. OurBoard of Directors has determined that Mr. Nichols qualifies as an“audit committee financial expert” under the federal securities laws.The Audit Committee’s responsibilities are set forth in an Audit CommitteeCharter, a copy of which can be found on the Company’s website,www.babyuniverse.com. The Audit Committee held six meetings during the yearended December 31, 2006.

          *CompensationCommittee*.  The Compensation Committee presently consists of Ms.Gottlieb, Mr. Nichols and Mr. Gimson, who serves as chairman. The CompensationCommittee is responsible for reviewing and recommending to the Board ofDirectors the compensation and benefits of all of our executive officers,administering our stock incentive plan and establishing and reviewing generalpolicies relating to compensation and benefits of our employees. TheCompensation Committee’s responsibilities are set forth in a CompensationCommittee Charter, a copy of which can be found on the Company’s website,www.babyuniverse.com.  The Compensation Committee held three meetingsduring the year ended December 31, 2006.

          *NominatingCommittee*. The Nominating Committee presently consists of Ms. Gottlieb, Mr.Stork and Mr. Gimson, who serves as chairman. The Nominating Committee isresponsible for identifying prospective Board of Directors candidates,recommending nominees for election to our Board of Directors, developing andrecommending Board of Directors member selection criteria, considering committeemember qualifications and providing oversight in the evaluation of the Board ofDirectors and each committee. The Nominating Committee will consider directornominee recommendations by shareholders, provided that the names of suchnominees and their relevant biographical information are properly submitted inthe manner described in the Company’s proxy statement relating to its 2006Annual Meeting of Shareholders under the caption “General Information– Shareholder Proposals and Director Nominations for 2007 AnnualMeeting.” The Nominating Committee’s responsibilities are set forth ina Nominating Committee Charter, a copy of which can be found on theCompany’s website, www.babyuniverse.com.  The Nominating Committeeheld one meeting during the year ended December 31, 2006.

**Code of Business Conduct and Ethics**

          Our Board ofDirectors has adopted a Code of Business Conduct and Ethics applicable to ourdirectors, officers and employees, in accordance with applicable federalsecurities laws and Nasdaq Marketplace Rules.  Our Code of Business Conductand Ethics is available to view at our website, www.babyuniverse.com.

49

**EXECUTIVE OFFICERS AND KEY EMPLOYEES**

          As of March 29,2007, each of the persons named below served as one of our executive officers orkey employees. 

**Name**

 

**Age**

 

**Position**

 

 

John C. Textor

 

41

 

Chief Executive Officer

Georgianne K. Brown

 

46

 

President Mainstream   eCommerce

Jonathan Teaford

 

33

 

Executive Vice President

Michael R. Hull

 

53

 

Chief Financial Officer

John Studdard

 

39

 

Executive Vice President –   New Media

          Each executiveofficer is appointed by and serves at the discretion of our Board of Directors,subject, in certain cases, to the terms of an employment agreement with theCompany.

          Below is a summaryof the business experience of each of our executive officers who do not serve onour Board of Directors.  

          Georgianne K. Brown,46, has been our President of Mainstream eCommerce since October 2006 and wasour Executive Vice President of Marketing from July 2005 to October 2006.Ms. Brown was formerly the Vice President for Marketing Services foreDiets.com, Inc., a public company that provides online diet and fitnesssubscription products and services, from November 2003 to April 2005.Ms. Brown held a variety of positions in Certified Vacations Group, Inc.from November 1997 to July 2003, holding the title of Vice President forConsumer Marketing from 1998 to 2003. In 1998, she also become the President ofNew River Technologies, a subsidiary of Certified Vacations Group, Inc.Ms. Brown held several marketing and sales related positions with AlamoRent A Car, Inc. from 1979 to 1997, and was the Executive Director of ConsumerMarketing for Alamo Rent A Car, Inc. from 1996 to 1997. 

          Michael R. Hull, 53,has been our Chief Financial Officer since December 2006.  From December2004 through December 2006, Mr. Hull assisted a large multinational company incomplying with Section 404 of the Sarbanes-Oxley Act of 2002.  PreviouslyMr. Hull served as Chief Financial Officer, Secretary and Treasurer of BCTInternational, Inc., a public company that franchised wholesale printingbusinesses, from May 1996 to August 2004.

            JohnStuddard, 39, has been our Executive Vice President of New Media since April2006. Mr. Studdard also served in the capacity of interim Chief TechnologyOfficer and served as an IT and management consultant to the Company from July2005 to March 2006.  Prior to joining the Company, Mr. Studdard was theChief Information Officer and Senior Vice President of Palm Beach, Florida-basedLydian Trust Company, by whom he was employed from 1990 until 2005.

**Section 16(a) Beneficial Ownership Reporting Compliance**

          Section 16(a) of theSecurities Exchange Act of 1934 requires our directors and executive officersand persons who own more than 10% of our outstanding Common Stock to file withthe Securities and Exchange Commission (“SEC”) reports of changes intheir ownership of Common Stock. Officers, directors and greater than 10%shareholders are also required to furnish us with copies of all forms they fileunder this regulation.  To our knowledge, based solely on a review of thecopies of such reports furnished to us and representations that no other reportswere required, during the year ended December 31, 2006, all Section 16(a) filingrequirements applicable to our officers, directors and greater than 10%shareholders were complied with, except that John C. Textor reported theacquisition on December 15, 2006 of 3,700 shares of the Company’s commonstock on a Form 4 filed with the SEC on December 21, 2006.

**ITEM 11.**

**EXECUTIVE   COMPENSATION**

**Compensation Discussion and Analysis**

          The followingdiscussions and tables in this Item 11 set forth information with regard tocompensation for services rendered in all capacities to the Company and itssubsidiaries during the year ended December 31, 2006, by the Chief ExecutiveOfficer (CEO), the Chief Financial Officer (CFO), the three most highlycompensated executive officers of the Company, other than the CEO and CFO, whowere serving as executive officers at December 31, 2006, and two additionalindividuals who were no longer serving as executive officers at December 31,2006 (the “Named Executive Officers”).  The information discussedbelow reflects the compensation earned by such individuals for services with theCompany and its subsidiaries during the covered periods.

50

***Company Compensation Objectives***

          The Company’sobjective is to maintain a program of executive compensation that is competitiveand motivating to the degree that it will attract, retain and inspireperformance of executive officers who possess qualities, talents and abilitiesthat will enhance the growth and profit potential of the Company.  TheCompany believes that its compensation program must include both short term andlong term compensation elements.  Our Board has organized a CompensationCommittee to establish the Company’s program of executivecompensation.

***Elements of Executive Compensation***

          The CompensationCommittee of the Company’s Board of Directors is responsible for overseeingour compensation programs. As part of that responsibility, the CompensationCommittee determines all compensation for the Chief Executive Officer and theCompany’s other executive officers as defined by SEC rules.

          The Company’sexecutive compensation program consists of a competitive base salary, equityparticipation either in the form of options to purchase shares of theCompany’s common stock or the granting of restricted shares of theCompany’s common stock, which, in each case, vest over a two to four yearperiod.  In addition, the Company has paid discretionary bonuses which arebased on the Compensation Committee’s assessment of the executive’scontribution to the Company. 

          The Company attemptsto set base salaries that are competitive with similar sized organizations, arecommensurate with each executive’s organizational responsibilities and hisor her level of professional development, taking into account the expected rolethe executive is likely to play in the helping the Company achieve its goals andobjectives.  In addition, after the Compensation Committee evaluated theroles and responsibilities of the executive officers, each executive officer wasallowed to invest in equity of the Company or was awarded equity in the form ofrestricted stock or stock options in connection with his or heremployment.  Equity-based compensation is designed to provide long-termincentives for the aligning of the Company’s goals and objectives with theexecutive’s performance and to reward performance that is accretive toshareholder value.  The Compensation Committee believes these arrangementsare reasonable and competitive compared to other companies the Company competeswith for the attraction and retention of talent.

          The executiveofficers do not receive any other compensation or benefits other than standardbenefits available to all employees, which primarily consist of health plans,the opportunity to participate in the Company’s 401(k) plan, basic lifeinsurance and accidental death insurance coverage.

***Equity Compensation Grants***

          The CompensationCommittee is responsible for establishing and administering the Company’sequity compensation programs and for awarding equity compensation to theexecutive officers. To date, the sole forms of equity compensation awarded to orpurchased by officers and employees have been restricted stock and stockoptions. The Compensation Committee believes that restricted stock and stockoptions are an important part of overall compensation because they align theinterests of officers and other employees with those of our shareholders andcreate long-term incentives to maximize shareholder value.

51

***Chief Executive Officer’s Compensation***

          The CompensationCommittee considered the following factors in determining the compensation forfiscal 2006 for John C. Textor, Chairman of the Board and Chief ExecutiveOfficer: the terms of his employment agreement with the Company and theCompany’s financial performance for 2005.  The base salary for Mr.Textor pursuant to the terms of his employment contract as of the beginning ofthe year was $90,000, subject to discretionary increases from time to time bythe Board of Directors or the Compensation Committee.  In November of 2006,the Board of Directors approved increasing Mr. Textor’s annual base salaryto $225,000. In establishing Mr. Textor’s base salary, the CompensationCommittee took into consideration the current compensation levels of CEOs ofcomparable ecommerce companies.

***Base Salaries of Other Executive Officers***

          Executiveofficers’ salaries are determined pursuant to the terms of their respectiveemployment agreements. In cases where base salary increases are at thediscretion of the Compensation Committee pursuant to the terms of an executiveofficer’s employment agreement, the Compensation Committee annually reviewsbase salaries and any increases are based on the Company’s overallperformance and the executive’s individual performance during the precedingyear. A cash bonus of $25,000 was paid to Georgianne K. Brown in 2006.  Noother cash bonuses were paid to executive officers in 2006.

***Review of all Components of Executive Compensation***

          The CompensationCommittee has reviewed all components of the executive officers’compensation, including salary, bonus, equity compensation, and accumulatedrealized and unrealized stock option gains. 

***Employment Agreements***

          Each of theCompany’s Named Executive Officers has entered into an employment agreementwith the Company, which establishes such executive officer’s base salaryand bonus, if applicable.  Among other things, the employment agreementsgenerally provide for severance, upon termination other than for cause,designate a period of employment, allow the termination of the agreement byeither party with notice and grant the right to participate in theCompany’s discretionary bonus program.

52

**Summary Compensation Table**

          The following tablepresents certain summary information, as applicable, for the fiscal years endedDecember 31, 2006, 2005 and 2004 concerning compensation earned for servicesrendered in all capacities to the Company and its subsidiaries by the NamedExecutive Officers during the covered periods.  In accordance with thenewly promulgated rules of the Securities and Exchange Commission related toExecutive Compensation disclosure, this table includes newly requiredinformation only for the Company’s fiscal year ended December 31,2006.

**Summary Compensation Table**

 

 

**Year**

 

**Salary ($)**

 

**Bonus ($)**

 

**Stock   Awards   ($)(2)**

 

**Option   Awards   ($)(3)**

 

**Non-Equity   Incentive Plan Compensation   ($)**

 

**Change in Pension Value and Non-qualified DeferredCompensation Earnings ($)**

 

**All Other   Compensation   ($)**

 

**Total ($)**

 

 

 

 

 

 

 

 

 

 

 

 

**John C.   Textor (1)**

 

 

2006

 

$

121,154

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

$

121,154

 

Chief Executive Officer

 

 

2005

 

$

71,539

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

$

71,539

 

 

 

 

2004

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

**Robert   Brown**

 

 

2006

 

$

105,442

 

 

—  

 

$

17,592

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

$

123,034

 

Former Chief Financial   Officer

 

 

2005

 

$

84,038

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

84,038

 

**Georgianne   Brown**

 

 

2006

 

$

104,577

 

$

25,000

 

$

12,315

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

$

141,892

 

President - Mainstream   eCommerce

 

 

2005

 

$

41,754

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

$

41,754

 

**John   Studdard**

 

 

2006

 

$

131,539

 

 

—  

 

 

—  

 

$

40,036

 

 

—  

 

 

—  

 

 

—  

 

$

171,574

 

Executive Vice President –   New Media

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**Michael R.   Hull**

 

 

2006

 

$

5,192

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

$

5,192

 

Chief Financial Officer

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**Karen Adams**

 

 

2006

 

$

131,250

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

$

131,250

 

Former President - Posh   Tots, Inc.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**Stuart   Goffman (1)**

 

 

2006

 

$

139,984

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

$

139,984

 

Former President and

 

 

2005

 

$

139,984

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$

139,984

 

Chief Operating Officer

 

 

2004

 

$

141,907

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

$

141,907

 

53

(1)

In April 2005, John C. Textor assumed the office of Chief Executive Officer, andStuart Goffman, our then President and Chief Executive Officer, became ourPresident and Chief Operating Officer, positions he resigned in October2006.

 

 

(2)

Stock awards consist of restricted shares of the Company’s common stock. InJuly 2005, the Company granted Mr. Brown and Ms. Brown restricted shares of theCompany’s commons stock of 42,222 and 29,555 shares, respectively. The restricted shares were valued at $52,777 and $36,943 based upon the fairvalue of the shares on the date of the grant of $1.25 per share. Thecompensation expense related to these shares has been recognized ratably overthe vesting period.  In addition, in December 2006, Mr. Hull was granted25,000 restricted shares with a fair market value of $171,000, based upon theclosing price of the Company’s common stock on the date of the grant, whichvest over a four year period.  The Company began recording compensationexpense for Mr. Hull’s shares in January 2007.

 

 

(3)

Mr. Studdard was granted options in April 2006 to purchase 50,000 shares of theCompany’s common stock with an exercise price of $8.10 per share, the fairmarket value on the date of the grant.  These options vest in quarterlyintervals over a four year period.  The options were valued using theBlack-Scholes option pricing model and are being recognized as compensationexpense in accordance with SFAS123R.

 

**Grants of Plan****-Based Awards**

The following table sets forth information concerning the grants of plan-basedawards to the Named Executive Officers under our BabyUniverse 2005 StockIncentive Plan during our last completed fiscal year:   

**Grants of Plan-Based Awards**

**Name**

 

**Grant   Date**

 

**Estimated   Future Payouts Under   Non-Equity Incentive Plan Awards**

 

**Estimated   Future Payouts Under   Equity Incentive Plan Awards**

 

**All Other   Stock   Awards:   Number of   Shares of   Stock or   Units (#)**

 

**All Other   Option   Awards:   Number of   Securities   Underlying   Options (#)**

 

 

**Exercise   or Base   Price of   Option   Awards   ($/Sh)**

 

 

**Grant Date   Fair Value   of Stock   and Option   Awards**

 

 

 

 

 

 

 

 

 

 

 

 

 

**Threshold   ($)**

 

**Target   ($)**

 

**Maximum   ($)**

 

**Threshold   (#)**

 

**Target   (#)**

 

**Maximum   (#)**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**John C.   Textor**

 

 

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

 

—  

 

 

—  

 

**Stuart   Goffman**

 

 

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

 

—  

 

 

—  

 

**Robert   Brown**

 

 

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

 

—  

 

 

—  

 

**Georgianne   Brown**

 

 

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

 

—  

 

 

—  

 

**John   Studdard**

 

4/03/06

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

50,000

 

$

9.86

 

$

9.86

 

**Michael R.   Hull**

 

12/11/06

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

25,000

 

—  

 

 

—  

 

$

6.84

 

**Karen   Adams (1)**

 

1/13/06

 

—  

 

—  

 

—  

 

—  

 

—  

 

—  

 

 

 

30,000

 

$

8.10

 

$

8.10

 

(1)

In September 2006, Karen Adams left the employment of the Company. Ms.Adams’ options were forfeited effective as of the date she left theCompany.

54

**Outstanding Equity Awards at Fiscal Year End**

          The following tableprovides certain information concerning unexercised options, stock that has notvested, and equity incentive plan awards for each Named Executive Officeroutstanding as of the end of the 2006 fiscal year:

**Outstanding Equity Awards at December 31, 2006**

 

 

**Option   Awards**

 

**Stock Awards**

 

 

 

 

 

**Name**

 

**Number of Securities Underlying Unexercised Options (#)Exercisable**

 

**Number of Securities Underlying Unexercised Options (#)Unexercisable**

 

**Equity Incentive Plan Awards: Number of SecuritiesUnderlying Unexercised Unearned Options (#)**

 

 

**Option   Exercise   Price ($)**

 

**Option   Expiration   Date**

 

**Number of Shares or Units of Stock That Have NotVested**

 

 

**Market Value of Shares or Units of Stock That HaveNot Vested**

 

**Equity Incentive Plan Awards: Number of UnearnedShares That Have Not Vested**

 

 

**Equity Incentive Plan Awards: Market Value ofUnearned Shares That Have Not Vested**

 

 

 

 

 

 

 

 

 

 

 

**John C.   Textor**

 

—  

 

—  

 

—  

 

 

—  

 

—  

 

—  

 

 

—  

 

—  

 

 

—  

 

**Stuart   Goffman**

 

—  

 

—  

 

—  

 

 

—  

 

—  

 

—  

 

 

—  

 

—  

 

 

—  

 

**Robert   Brown**

 

—  

 

—  

 

—  

 

 

—  

 

—  

 

—  

 

 

—  

 

25,333

 

$

183,664

 

**Georgianne   Brown**

 

—  

 

—  

 

—  

 

 

—  

 

—  

 

—  

 

 

—  

 

18,999

 

$

137,743

 

**John   Studdard**

 

8,333

 

41,667

 

41,667

 

$

9.86

 

4/3/09

 

—  

 

 

—  

 

—  

 

 

—  

 

**Michael R.   Hull**

 

—  

 

—  

 

—  

 

 

—  

 

—  

 

—  

 

 

—  

 

25,000

 

$

181,250

 

**Karen   Adams**

 

—  

 

—  

 

—  

 

 

—  

 

—  

 

—  

 

 

—  

 

—  

 

 

—  

 

55

          The following tableprovides information regarding the options exercised by, and the vesting ofstock for, the Named Executive Officers during fiscal 2006 and the valuerealized on such exercise or vesting:

 

 

**Option   Awards**

 

**Stock   Awards**

 

 

 

 

 

 

 

**Number of   Shares Acquired   on Exercise (#)**

 

**Value   Realized   on Exercise ($)**

 

**Number of   Shares of Stock   Acquired on   Vesting ($) (1)**

 

**Value Realized   on Vesting ($) (1)**

 

 

 

 

 

 

 

**John C.   Textor**

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

**Stuart   Goffman**

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

**Robert   Brown**

 

 

—  

 

 

—  

 

 

16,890

 

$

130,898

 

**Georgianne   Brown**

 

 

—  

 

 

—  

 

 

10,556

 

$

89,409

 

**John   Studdard**

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

**Michael R.   Hull**

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

**Karen Adams**

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

(1)

Based on the fair market   value of our Common Stock on the date of vesting.

56

**Pension Benefits and Nonqualified Deferred Compensation**

          The Company has notprovided, and does not currently provide, any form of post-retirement benefitsto its employees or any of the Named Executive Officers.  In addition, theCompany has never had, and currently does not have, any nonqualified deferredcompensation plans in place.

**Employment Agreements**

          We previouslyentered into employment agreements with John C. Textor, our Chairman of theBoard and Chief Executive Officer, Jonathan Teaford, our Executive VicePresident, Robert Brown, our former Chief Financial Officer, and GeorgianneK. Brown, our former Executive Vice President of Marketing.  During2006 we entered into employment agreements with John Studdard, our ExecutiveVice President for New Media, and Michael R. Hull, our Chief Financial Officer,ratified amendments to the employment agreements for John C. Textor and JonathanTeaford and entered into a new employment agreement with Georgianne K. Brown forher new position of President - Mainstream eCommerce. The employment agreementswith Messrs. Textor, Teaford and Brown are each for initial terms of threeyears, with successive one year extensions unless we or the employee timelyprovides the required notice of the intent not to renew the agreement. Mr. Brownresigned his position in October 2006. The employment agreements withMs. Brown and Mr. Hull are for initial terms of one year, with successiveone year extensions unless we or they timely provide the required notice of theintent not to renew the agreement. The new agreements and the ratifiedamendments provide for annual base salaries of $225,000 for Mr. Textor,$180,000 for Mr. Studdard, $120,000 for Mr. Teaford, $140,000 forMs. Brown and $135,000 for Mr. Hull, plus discretionary annual cash bonusesdetermined by the Compensation Committee of our Board of Directors.  Inaddition, Mr. Studdard received options to purchase 50,000 shares of our commonstock which vest quarterly over four years.  Mr. Hull received 25,000shares of restricted common stock vesting over four years.

          Each of theagreements also prohibits the employee from competing with us with respect toany business that is engaged in selling brand name baby, toddler, kids ormaternity products, for the period of employment and for three years thereafter.The agreements also prohibit the employees from soliciting our customers todivert their business away from us or soliciting our employees or independentcontractors to work for a business that competes with us, or for our suppliers,for the period of his or her employment and for three years thereafter.

          The agreementsprovide that if (1) a change of control (as described below) occurs,(2) such change of control results in a decrease in the employee’scompensation, responsibilities or position, such that the employee cannot ingood faith continue to fulfill his or her job responsibilities (as determined bythe employee in his/her sole discretion during the six month period followingthe change of control), and (3) the change of control did not occur due tothe employee’s intentional bulk sale of his or her shares of our commonstock, then the employee has the right to terminate his or her employmentagreement and receive in one lump sum a payment equivalent to his or her accruedsalary and benefits plus a severance benefit equal to one-twelfth of his or herthen base salary with an additional one-twelfth of his or her then base salaryfor each full calendar year that the employment agreement and any extensionthereof shall have been in effect and any applicable expense reimbursements. A“change of control” generally means a merger or other change incorporate structure after which the majority of our capital stock is no longerheld by the shareholders who held such shares prior to the change of control, asale of substantially all of our assets to a non-subsidiary purchaser or areorganization merger or consolidation in which we or a subsidiary is not thesurviving corporation.

57

          The following tabledescribes potential payments to the Named Executive Officers at, following or inconnection with any termination of their employment with the Company, including,without limitation, as a result of resignation, severance, retirement or achange in control of the Company or material changes in the Named ExecutiveOfficer’s responsibilities or status at the Company:

 

 

 

 

**Before Change in   Control**

 

**After Change in   Control**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

**Name**

 

**Benefit**

 

**Termination w/o   Cause or Good   Reason**

 

**Termination w/o   Cause or Good   Reason**

 

**Voluntary   Termination**

 

**Death**

 

**Disability**

 

**Change in   Control**

 

 

 

 

 

 

 

**John C.   Textor**

 

Up   to one half of annual salary

 

Yes

 

Yes

 

No

 

No

 

No

 

Yes

**Jonathan   Teaford**

 

Up   to one half of annual salary

 

Yes

 

Yes

 

No

 

No

 

No

 

Yes

**Stuart   Goffman**

 

None

 

No

 

No

 

No

 

No

 

No

 

No

**Robert   Brown**

 

None

 

No

 

No

 

No

 

No

 

No

 

No

**Georgianne   Brown**

 

Up   to one half of annual salary

 

Yes

 

Yes

 

No

 

No

 

No

 

Yes

**John   Studdard**

 

Up   to one half of annual salary

 

Yes

 

Yes

 

No

 

No

 

No

 

Yes

**Michael R.   Hull**

 

Up   to one half of annual salary

 

Yes

 

Yes

 

No

 

No

 

No

 

Yes

**Compensation of Directors**

          The following tableprovides a summary of compensation paid to the Company’s non-employeedirectors during the year ended December 31, 2006:

**Director Compensation**

**Name**

 

**Fees   Earned   or Paid in   Cash ($)**

 

**Stock   Awards ($)**

 

**Option   Awards ($)**

 

**Non-Equity   Incentive   Plan Compensation ($)**

 

**Change in Pension Value and Non-qualified DeferredCompensation Earnings ($)**

 

**All Other   Compensation ($)**

 

**Total ($)**

 

 

 

 

 

 

 

 

 

**Carl Stork**

 

$

8,500

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

$

8,500

 

**John   Nichols**

 

$

9,500

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

$

9,500

 

**Curtis Gimson**

 

$

9,500

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

$

9,500

 

**Bethel   Gottlieb**

 

$

7,000

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

$

7,000

 

**Compensation Committee Interlocks and Insider Participation
           During the fiscalyear ended December 31, 2006, the Compensation Committee of the Board ofDirectors of the Company was comprised of Bethel G. Gottlieb, John Nichols, andCurtis Gimson, who served as Chairman. No other disclosures concerning any suchmember of the Compensation Committee are required to be included under thiscaption in this Annual Report on Form 10-K.

58

**COMPENSATION COMMITTEE REPORT**

          *The informationcontained in this report shall not be deemed to be “solicitingmaterial” or “filed” or incorporated by reference in futurefilings with the SEC, or subject to the liabilities of Section 18 of theSecurities Exchange Act of 1934, except to the extent that we specificallyincorporate it by reference into a document filed under the Securities Act of1933 or the Securities Exchange Act of 1934.*

          The members of theCompensation Committee of the Company’s Board of Directors have reviewedand discussed the Compensation Discussion and Analysis appearing in this AnnualReport on Form 10-K with management, and based upon such review and discussion,the Compensation Committee recommended to the Company’s Board of Directorsthat such Compensation Discussion and Analysis be included in this Annual Reporton Form 10-K.

 

*The   Compensation Committee*

 

**Curtis   Gimson**

 

**Bethel G.   Gottlieb**

 

**John Nichols**

**ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT AND RELATED STOCKHOLDER MATTERS**

**SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT**

          The following tablesets forth certain information regarding the beneficial ownership of our commonstock as of March 20, 2007 by: 

 

•

each person known by us to be the beneficial owner of more than fivepercent (5%) of our outstanding shares of our common stock;

 

 

 

 

•

each of our executive   officers and directors; and

 

 

 

 

•

all of our executive   officers and directors as a group.

          Beneficial ownershipis determined in accordance with the rules of the SEC and includes voting orinvestment power with respect to the shares. In computing the number of sharesbeneficially owned by a person and the percentage ownership of that person,shares of Common Stock subject to options or warrants held by that person thatare currently exercisable or will become exercisable within 60 days afterMarch 20, 2007, are deemed outstanding, while the shares are not deemedoutstanding for purposes of computing percentage ownership of any other person.Except as otherwise indicated, and subject to applicable community propertylaws, the persons named in the table have sole voting and investment power withrespect to all shares of common stock held by them.  

          Applicablepercentage ownership in the following table is based on 5,686,470 shares ofCommon Stock outstanding as of March 20, 2007. Unless otherwise indicated, theaddress where each of the shareholders in the table below may be contacted isc/o BabyUniverse, Inc., 150 South US Highway One, Suite 500, Jupiter,Florida 33477. 

59

**Name**

 

**Number of   Shares Beneficially   Owned**

 

**Percent of   Common Stock**

 

 

 

 

**5% Shareholders**

 

 

 

 

 

 

 

Wyndcrest BabyUniverse   Holdings II, LLC

 

 

579,458

 

 

10.2

%

Wyndcrest BabyUniverse Holdings III, LLC

 

 

1,209,006

 

 

21.3

%

Richard H. Pickup (1)

 

 

657,500

 

 

11.6

%

**Executive Officers and Directors**

 

 

 

 

 

 

 

John C. Textor (2) (3)

 

 

2,070,525

 

 

36.4

%

Stuart Goffman (4)

 

 

367,933

 

 

6.5

%

Jonathan Teaford (3) (5)

 

 

78,028

 

 

1.4

%

Robert Brown (6)

 

 

17,444

 

 

0.3

%

Georgianne K. Brown (7)

 

 

10,556

 

 

0.2

%

Curtis Gimson (8)

 

 

21,361

 

 

0.4

%

Bethel G. Gottlieb (8)

 

 

16,361

 

 

0.3

%

John Nichols (9)

 

 

52,124

 

 

0.9

%

Carl Stork (10)

 

 

52,124

 

 

0.9

%

John Studdard (11)

 

 

16,666

 

 

0.3

%

All current or former   directors and executive officers as a group (11 persons)

 

 

2,862,206

 

 

47.0

%

(1)

As reflected in Amendment No. 1 to aSchedule 13D filed on February 14, 2007; Mr. Pickup’s address, as reflectedtherein, is 2321 Alcova Ridge Dr., Las Vegas, Nevada, 89134.

(2)

Includes 28,460 shares owned by WyndcrestBabyUniverse Holdings, LLC, 579,458 shares owned by Wyndcrest BabyUniverseHoldings II, LLC and 1,209,006 shares owned by Wyndcrest BabyUniverse HoldingsIII, LLC.  John C. Textor holds sole investment and voting power over theshares held by the Wyndcrest entities, except as affected by the VotingAgreement refernced in Footnote (3) below.

(3)

All of these shares are covered by a Voting Agreement to which eToys Direct,Inc. and Mr. Textor and Mr. Teaford, among others, are party, which is described in theCompany’s Current Report on Form 8-K filed on March 16, 2007.

(4)

5,000 of these shares are covered by a Voting Agreement to which eToys Direct,Inc. and Mr. Goffman, among others, are party, which is described in theCompany’s Current Report on Form 8-K filed on March 16, 2007.

(5)

Although Mr. Teaford is affiliated with the Wyndcrest entities referred to inFootnote (2) above, he is not deemed to beneficially own shares held throughsuch entities because he does not control the voting or disposition of suchshares.

(6)

Excludes 33,778 shares of unvested restricted stock which are subject totime-based vesting restrictions.

(7)

Excludes 24,277 shares of unvested restricted stock which are subject totime-based vesting restrictions.

(8)

Excludes 16,361 shares of unvested restricted stock which are subject to timebased vesting restrictions.

(9)

Includes 52,124 shares issuable under currently exercisable stockoptions.

(10)

Consists of 52,124 shares owned by Ciconia & Co. LLC.  Mr. Stork holdssole investment and voting power over the shares held by Ciconia & Co.LLC.  Although Mr. Stork is affiliated with the Wyndcrest entities referredto in footnote (2) above, he is not deemed to beneficially own shares heldthrough such entities because he does not control the voting or disposition ofsuch shares.

(11)

Includes 16,666 shares issuable under stock options exercisable within 60 days of March 20, 2007.

60

**Equity Compensation Plan Information**

          The following tablesets forth information, as of December 31, 2006, with respect to ourcompensation plans under which Common Stock is or was authorized for issuanceand is outstanding:

**Plan Category**

 

**Number of Securities to be Issued Upon Exercise of OutstandingOptions, Warrants and Rights**

 

**Weighted-Average Exercise Price of Outstanding Options, Warrantsand Rights**

 

**Number of Securities Remaining Available for Future IssuanceUnder Equity Compensation Plans**

 

 

 

 

 

Equity compensation plans   approved by security holders

 

 

104,248

(1)

$

3.15

 

 

288,235

 

Equity compensation plans   not approved by security holders

 

 

—  

 

 

—  

 

 

—  

 

 

 

 

 

 

Total

 

 

104,248

 

$

3.15

 

 

288,235

 

 

 

 

 

 

(1)

Excludes 177,221 shares of   restricted stock subject to time-based vesting.

**Change in Control**

          In the event thatthe Company’s proposed merger with eToys Direct, Inc. is consummated, theCompany will undergo a change of control, with the shareholders of eToys Direct,Inc. immediately prior to the consummation of the merger owning, in theaggregate, approximately two-thirds of the outstanding Common Stock immediatelyafter such consummation.

**ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, ANDDIRECTOR INDEPENDENCE**

**Certain Relationships and Related Transactions
          On September 22,2006, the Company closed on $2 million in new equity financing.  The equityfinancing was provided by affiliates of Wyndcrest Holdings, LLC, a companycontrolled by our Chairman and Chief Executive Officer John C. Textor.  Inconnection with the financing, the Company received aggregate proceeds ofapproximately $2 million, based on the issuance of 263,852 shares of our commonstock priced at $7.58 per share, a 7.5% premium to the closing price onSeptember 22, 2006.

          On December 29,2006, the Company entered into a Loan Agreement (the “Lydian LoanAgreement”) with Lydian Private Bank, pursuant to which Lydian Private Bankprovided a term loan of $2,000,000 to the Company (the “Lydian Loan”),evidenced by a Promissory Note in that principal amount dated December 29, 2006(the “Lydian Note”). The Lydian Loan bears interest at a floating rateof interest equal to the base rate on corporate loans posted by at least 75% ofthe nation’s largest banks, known as the “Wall Street JournalPrime,” which interest is payable monthly beginning on February 1, 2007.The maturity date of the Lydian Loan is July 1, 2008, at which time alloutstanding principal and accrued but unpaid interest thereunder must be repaidto Lydian Private Bank. 

          As securityfor the Lydian Loan, Wyndcrest Baby Universe Holdings II, LLC, a Florida limitedliability company, and Wyndcrest BabyUniverse Holdings III, LLC, a Floridalimited liability company, each of which is controlled by Mr. Textor, pledged toLydian Private Bank shares of our Common Stock held by them, which shares alsoserve as collateral under a loan previously extended to such pledgors by LydianPrivate Bank. In addition, each such pledgor and Mr. Textor have executed aguaranty of the Lydian Loan in favor of Lydian Private Bank. The Lydian LoanAgreement and the Lydian Note contain customary events of default for facilitiesof this type; upon the occurrence of any such event of default, Lydian PrivateBank shall be entitled to all rights and remedies available to it against theCompany under law and the Lydian Loan Agreement and the Lydian Note, including,without limitation, the right to accelerate and demand immediate repayment ofall sums due thereunder.

**Director Independence
           Informationrelating to the independence of the members of our Board of Directors ispresented in Item 10 of this Annual Report on Form 10-K under the caption“Independence of the Board”, and is incorporated into this Item 13 bythis reference.

**ITEM 14.   PRINCIPAL ACCOUNTING FEES AND SERVICES**

***Audit Fees***

          The aggregate feesbilled by Singer Lewak Greenbaum & Goldstein LLP (“Singer Lewak”)for fiscal 2006 and 2005 for professional services rendered for the audit of ourannual financial statements and for the review of the financial statementsincluded in our Quarterly Reports on Form 10-Q or services that are normallyprovided in connection with statutory and regulatory filings or engagement forthose fiscal years were $198,980 and $113,307, respectively.

61

***Audit Related Fees***

          The aggregate feesbilled by Singer Lewak for fiscal 2006 and 2005 for assurance and relatedservices that are reasonably related to the performance of the audit or reviewof our financial statements, including the audit of financial statements relatedto acquisition candidates, and other than those services reported under“Audit Fees” above, for those fiscal years were $158,455 and $108,132,respectively.

***Tax Fees***

          The aggregate feesbilled by Singer Lewak for fiscal 2006 and 2005 for professional servicesrendered for tax compliance, tax advice and tax planning were $24,494 and$4,798, respectively.

***All Other Fees***

          No fees were billedby Singer Lewak for fiscal 2006 and 2005, other than for the services describedabove under “Audit Fees,” “Audit Related Fees” and “TaxFees”. 

***Pre-Approval Policies and Procedures for Audit and Permitted Non-AuditServices***

          The Audit Committeehas a policy of considering and, if deemed appropriate, approving, on a case bycase basis, any audit or permitted non-audit service proposed to be performed bySinger Lewak in advance of the performance of such service.  These servicesmay include audit services, audit-related services, tax services and otherservices.  The Audit Committee has not implemented a policy or procedurewhich delegates the authority to approve, or pre-approve, audit or permittednon-audit services to be performed by Singer Lewak.  In connection withmaking any pre-approval decision, the Audit Committee must consider whether theprovision of such permitted non-audit services by Singer Lewak is consistentwith maintaining Singer Lewak’s status as our independent auditors. 

          Consistent withthese policies and procedures, the Audit Committee approved all of the servicesrendered by Singer Lewak during fiscal year 2006, as describedabove.   

**PART IV
**ITEM 15.   EXHIBITS, FINANCIAL STATEMENTSCHEDULES**

(a)   Documents   filed as part of this report:

 

 

 

 

 

 

(1)

Financial Statements

 

 

 

 

 

 

The following consolidated financial statements of BabyUniverse, Inc. andsubsidiaries, Report of Singer Lewak Greenbaum & Goldstein LLP, independentregistered public accounting firm, and Report of Lieberman & Associates,P.A., independent registered public accounting firm, are included in thisreport:

 

 

 

 

 

 

 

 

**Page**

 

 

 

 

Report of Singer Lewak Greenbaum &Goldstein LLP, Independent Registered Public Accounting Firm

F-2

 

Report of Lieberman & Associates,P.A., Independent Registered Public Accounting Firm

F-3

 

Consolidated Balance   Sheets

F-4

 

Consolidated Statements of Operations

F-5

 

Consolidated Statements of Stockholders’ Equity(Deficit)

F-6

 

Consolidated Statements of   Cash Flows

F-7

 

Notes to Consolidated Financial Statements

F-8

 

 

 

 

 

(2)

Financial Statement   Schedules

 

 

 

 

 

 

All schedules for which provision is made in the applicable accountingregulations of the Securities and Exchange Commission are not required under therelated instructions or are inapplicable and therefore have beenomitted.

 

 

 

 

 

 

(3)

Exhibits

 

62

**Exhibit Number**

 

**Description**

 

2.1

 

Asset Purchase Agreement, dated as of January 13, 2006, among Poshbaby, Inc.,Posh Tots, L.L.C., Karen Booth Adams and Michael Dru Adams (incorporated byreference to Exhibit 2.1 to the Current Report on Form 8-K (File No. 001-32577)filed by BabyUniverse, Inc. on January 20, 2006

 

 

 

2.2

 

Asset Purchase Agreement, dated as of June 14, 2006, among Majestic Media, LLC,Grace Enterprises, L.L.C., and BabyUniverse, Inc. (incorporated by reference toExhibit 2.1 to the Quarterly Report on Form 10-Q (File No. 001-32577) filed byBabyUniverse, Inc. on August 14, 2006

 

 

 

3.1

 

Form of Amended and Restated Articles of Incorporation (incorporated byreference to Exhibit 3.1 to the Registration Statement on Form S-1/A(Registration No. 333-124395) filed by BabyUniverse, Inc. on April 28,2005)

 

 

 

3.2

 

Form of Amended Bylaws (incorporated by reference to Exhibit 3.2 to theRegistration Statement on Form S-1/A (Registration No. 333-124395) filed byBabyUniverse, Inc. on April 28, 2005)

 

 

 

4.1

 

Specimen Common Stock certificate (incorporated by reference to Exhibit 4.1 tothe Registration Statement on Form S-1/A (Registration No. 333-124395) filedby BabyUniverse, Inc. on July 13, 2005).

 

 

 

4.2

 

Amendment to Common Stock Purchase Warrant, dated as of May 11, 2006, betweenBabyUniverse, Inc. and GunnAllen Financial, Inc. (incorporated by reference toExhibit 4.1 to the Quarterly Report on Form 10-Q (File No. 001-32577) filed byBabyUniverse, Inc. on May 15, 2006)

 

 

 

4.3

 

Senior Loan and Security Agreement, dated as of July 11, 2006, betweenBabyUniverse, Inc., and each of its subsidiaries, and Hercules Technology GrowthCapital, Inc. (incorporated by reference to Exhibit 4.1 to the Current Report onForm 8-K (File No. 001-32577) filed by BabyUniverse, Inc. on July 14,2006)

 

 

 

4.4

 

Warrant Agreement, dated as of July 11, 2006, between BabyUniverse, Inc. andHercules Technology Growth Capital, Inc. (incorporated by reference to Exhibit4.1 to the Current Report on Form 8-K (File No. 001-32577) filed byBabyUniverse, Inc. on July 14, 2006)

 

 

 

10.1

 

BabyUniverse, Inc. Stock Incentive Plan (incorporated by reference to Exhibit10.1 to the Registration Statement on Form S-1/A (Registration No. 333-124395)filed by BabyUniverse, Inc. on April 28, 2005)

 

 

 

10.2

 

Loan Agreement, dated as of December 29, 2006, between BabyUniverse, Inc. andLydian Private Bank (incorporated by reference to Exhibit 10.1 to the CurrentReport on Form 8-K (File No. 001-32577) filed by BabyUniverse, Inc. on January5, 2007)

 

 

 

10.3

 

Promissory Note, dated as of December 29, 2006, issued by BabyUniverse, Inc. toLydian Private Bank (incorporated by reference to Exhibit 10.2 to the CurrentReport on Form 8-K (File No. 001-32577) filed by BabyUniverse, Inc. on January5, 2007)

 

 

 

10.4

 

Employment Contract, dated as of January 13, 2006, between Poshbaby, Inc., andKaren Booth Adams (incorporated by reference to Exhibit 10.1 to the QuarterlyReport on Form 10-Q (File No. 001-32577) filed by BabyUniverse, Inc. on May 15,2006)

 

 

 

10.5

 

Employment Contract, dated as of January 13, 2006, between Poshbaby, Inc., andAndrea Edmunds (incorporated by reference to Exhibit 10.2 to the QuarterlyReport on Form 10-Q (File No. 001-32577) filed by BabyUniverse, Inc. on May 15,2006)

 

 

 

10.6

 

Employment Contract, dated as of January 13, 2006, between Poshbaby, Inc., andSusan Lindeman (incorporated by reference to Exhibit 10.3 to the QuarterlyReport on Form 10-Q (File No. 001-32577) filed by BabyUniverse, Inc. on May 15,2006)

63

10.7

 

Employment Contract, dated as of April 3, 2006, between BabyUniverse, Inc., andJohn Studdard (incorporated by reference to Exhibit 10.1 to the Quarterly Reporton Form 10-Q (File No. 001-32577) filed by BabyUniverse, Inc. on August 14,2006)

 

 

 

10.8

 

Amendment No. 1, dated as of November 10, 2006, to the Employment Agreement,dated as of April 1, 2005, between John C. Textor and BabyUniverse, Inc.(incorporated by reference to Exhibit 10.3 to the Quarterly Report on Form 10-Q(File No. 001-32577) filed by BabyUniverse, Inc. on November 14,2006)

 

 

 

10.9

 

Amendment No. 1, dated as of November 10, 2006, to the Employment Agreement,dated as of April 1, 2005, between Jonathan Teaford and BabyUniverse, Inc.(incorporated by reference to Exhibit 10.4 to the Quarterly Report on Form 10-Q(File No. 001-32577) filed by BabyUniverse, Inc. on November 14,2006)

 

 

 

10.10

 

Amendment No. 1, dated as of November 10, 2006, to the Employment Agreement,dated as of July 11, 2005, between Georgianne Brown and BabyUniverse, Inc.(incorporated by reference to Exhibit 10.5 to the Quarterly Report on Form 10-Q(File No. 001-32577) filed by BabyUniverse, Inc. on November 14,2006)

 

 

 

10.11

 

Employment Contract, dated as of November 28, 2006, between BabyUniverse, Inc.,and Michael R. Hull (incorporated by reference to Exhibit 10.1 to the CurrentReport on Form 8-K (File No. 001-32577) filed by BabyUniverse, Inc. on December4, 2006)

 

 

 

21.1

 

Subsidiaries of Registrant

 

 

 

23.1

 

Consent of Singer Lewak Greenbaum & Goldstein LLP, Independent RegisteredPublic Accounting Firm

 

 

 

23.2

 

Consent of Lieberman & Associates, P.A., Independent Registered PublicAccounting Firm

 

 

 

31.1

 

Certification by John C. Textor, Chief Executive Officer, pursuant to Section302 of the Sarbanes-Oxley Act of 2002

 

 

 

31.2

 

Certification by Michael Hull, Chief Financial Officer, pursuant to Section 302of the Sarbanes-Oxley Act of 2002

 

 

 

32.1

 

Certification by John C. Textor, Chief Executive Officer, pursuant to Section906 of the Sarbanes-Oxley Act of 2002

 

 

 

32.2

 

Certification by Michael Hull, Chief Financial Officer, pursuant to Section 906of the Sarbanes-Oxley Act of 2002

64

**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 

BABYUNIVERSE, INC.

 

 

 

 

 

 

 

By:

/s/  JOHN C.   TEXTOR

 

 

 

 

JOHN C. TEXTOR

 

 

Chief Executive Officer   and Chairman of the Board of Directors

 

 

 

 

Date

April 2, 2007

Pursuant to the requirements of the Securities Exchange Act of 1934, this reporthas been signed below by the following persons on behalf of the registrant andin the capacities and on the dates indicated.

**Signature**

 

**Title**

 

**Date**

 

 

/s/   JOHN C. TEXTOR

 

Chief Executive Officer   (Principal Executive Officer)

 

April 2, 2007

 

and Chairman of the Board   of Directors

 

 

**John C.   Textor**

 

 

 

 

 

 

 

 

 

/s/  MICHAEL   HULL

 

Chief Financial Officer

 

April 2, 2007

 

(Principal Financial and   Accounting Officer)

 

 

**Michael   Hull**

 

 

 

 

 

 

 

 

 

/s/  STUART   GOFFMAN

 

Director

 

April 2, 2007

 

 

 

 

**Stuart   Goffman**

 

 

 

 

 

 

 

 

 

/s/ JONATHAN TEAFORD

 

Executive Vice President   and Director

 

April 2, 2007

 

 

 

 

**Jonathan   Teaford**

 

 

 

 

 

 

 

 

 

/s/  CURTIS S.   GIMSON

 

Director

 

April 2, 2007

 

 

 

 

**Curtis S.   Gimson**

 

 

 

 

 

 

 

 

 

/s/  BETHEL G.   GOTTLIEB

 

Director

 

April 2, 2007

 

 

 

 

**Bethel G.   Gottlieb**

 

 

 

 

 

 

 

 

 

/s/  JOHN   NICHOLS

 

Director

 

April 2, 2007

 

 

 

 

**John   Nichols**

 

 

 

 

 

 

 

 

 

/s/  CARL STORK

 

Director

 

April 2, 2007

 

 

 

 

**Carl   Stork**

 

 

 

 

65

**BABYUNIVERSE, INC. AND SUBSIDIARIES**

**INDEX TO FINANCIAL STATEMENTS**

Report of Singer Lewak Greenbaum & Goldstein LLP, Independent RegisteredPublic Accounting Firm

 

F-2

 

 

 

Report of Lieberman & Associates, P.A., Independent Registered PublicAccounting Firm

 

F-3

 

 

 

Consolidated Balance Sheets - as of December 31, 2006 and 2005

 

F-4

 

 

 

Consolidated Statements of Operations – for the years ended December 31,2006, 2005 and 2004

 

F-5

 

 

 

Consolidated Statements of Stockholders’ Equity (Deficit) – for theyears ended December 31, 2006, 2005 and 2004

 

F-6

 

 

 

Consolidated Statements of Cash Flows – for the years ended December 31,2006, 2005 and 2004

 

F-7

 

 

 

Notes to the Consolidated   Financial Statements

 

F-8

F-1

**Report of Independent Registered Public AccountingFirm**

To the Board of Directors BabyUniverse, Inc. and subsidiaries Jupiter,Florida

We have audited the consolidated balance sheets of BabyUniverse, Inc. andsubsidiaries as of December 31, 2006 and 2005, and the related consolidatedstatements of operations, shareholders’ equity (deficit) and cash flows foreach of the two years in the period ended December 31, 2006. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

We conducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we planand perform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on atest basis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of BabyUniverse, Inc.and subsidiaries as of December 31, 2006 and 2005, and the results of theiroperations and their cash flows for each of the two years in the period endedDecember 31, 2006, in conformity with U.S. generally accepted accountingprinciples. 

SINGER LEWAK GREENBAUM & GOLDSTEIN, LLP

Los Angeles, California March 31, 2007

F-2

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

To the Board of Directors   and Stockholders

BabyUniverse, Inc.

Ft. Lauderdale, Florida

          We have audited theaccompanying consolidated statements of operations, shareholder’sdeficit and cash flows of BabyUniverse, Inc. for the year ended December31, 2004.  These consolidated financial statements are the responsibilityof the Company’s management.  Our responsibility is to express anopinion on these consolidated financial statements based on ouraudit.

          We conducted ouraudit in accordance with the standards of the Public Company AccountingOversight Board (United States).  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the consolidatedfinancial statements are free of material misstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe consolidated financial statements.  An audit also includes assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall consolidated financial statement presentation. Webelieve that our audit provides a reasonable basis for our opinion.

          In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the consolidated statements of operations,shareholders’ deficit, and cash flows of BabyUniverse, Inc. for the year ended December 31, 2004, in conformity with U.S. generally acceptedaccounting principles.

/s/ Lieberman &   Associates, P.A.

 

 

Lieberman &   Associates, P.A.

 

Ft. Lauderdale, Florida

 

June 13, 2005

 

F-3

**BabyUniverse, Inc. and Subsidiaries ConsolidatedBalance Sheets**

 

 

**December   31,**

 

 

 

 

 

 

**2006**

 

**2005**

 

 

 

 

 

**Assets**

 

 

 

 

 

 

 

Cash

 

$

3,473,278

 

$

9,925,806

 

Accounts Receivable

 

 

732,186

 

 

788,405

 

Inventory, Net

 

 

2,048,485

 

 

1,237,659

 

Prepaid Expenses

 

 

331,457

 

 

275,532

 

 

 

 

 

**Total Current Assets**

 

 

6,585,406

 

 

12,227,402

 

Fixed Assets - Net

 

 

1,936,740

 

 

666,793

 

Intangible Assets - Net

 

 

2,811,627

 

 

176,972

 

Deposits

 

 

137,760

 

 

45,644

 

Goodwill

 

 

18,832,041

 

 

6,620,057

 

 

 

 

 

**Total Assets**

 

$

30,303,574

 

$

19,736,868

 

 

 

 

 

**Liabilities   and Stockholders’ Equity (Deficit)**

 

 

 

 

 

 

 

Accounts Payable

 

$

4,664,107

 

$

2,621,424

 

Accrued Expenses

 

 

501,704

 

 

519,613

 

Gift Certificate Liability

 

 

115,192

 

 

69,188

 

Notes and Capital Lease   Payable - Current Portion

 

 

561,090

 

 

3,300

 

Deferred Revenue

 

 

787,758

 

 

358,064

 

 

 

 

 

**Total Current Liabilities**

 

 

6,629,851

 

 

3,571,589

 

Deferred Rent

 

 

189,542

 

 

15,543

 

Note and Capital Lease   Payable - Long Term Portion

 

 

5,777,841

 

 

4,761

 

 

 

 

 

**Total Liabilities**

 

 

12,597,234

 

 

3,591,893

 

**Stockholders’   Equity**

 

 

 

 

 

 

 

Preferred Stock, $.001 par value, 10,000,000 shares authorized, no sharesissued

 

 

—  

 

 

—  

 

Common Stock, $.001 par value, 50,000,000 shares authorized, 5,686,470 and5,125,203 shares issued and outstanding at December 31, 2006 and 2005,respectively

 

 

5,686

 

 

5,125

 

Additional Paid in Capital

 

 

23,943,189

 

 

19,592,369

 

Unearned Compensation

 

 

—  

 

 

(553,684

)

Accumulated Deficit

 

 

(6,242,535

)

 

(2,898,835

)

 

 

 

 

**Total Stockholders’ Equity**

 

 

17,706,340

 

 

16,144,975

 

 

 

 

 

**Total Liabilities and Stockholders’ Equity**

 

$

30,303,574

 

$

19,736,868

 

 

 

 

 

The accompanying notes are an integral part of these consolidated financialstatements.

F-4

**BabyUniverse, Inc. and Subsidiaries ConsolidatedStatements of Operations**

 

 

**For the   Year Ended December 31,**

 

 

 

 

 

 

**2006**

 

**2005**

 

**2004**

 

 

 

 

 

 

**Gross   sales**

 

$

37,757,600

 

$

24,512,026

 

$

14,787,658

 

Less   - discounts & returns

 

 

(2,207,902

)

 

(809,571

)

 

(521,028

)

 

 

 

 

 

**Net sales**

 

 

35,549,698

 

 

23,702,455

 

 

14,266,630

 

**Cost of   goods sold**

 

 

25,389,702

 

 

17,417,416

 

 

10,590,299

 

 

 

 

 

 

**Gross   profit**

 

 

10,159,996

 

 

6,285,039

 

 

3,676,331

 

 

 

 

 

 

**Operating   expenses:**

 

 

 

 

 

 

 

 

 

 

Advertising

 

 

4,652,486

 

 

3,491,656

 

 

1,927,836

 

Salaries   and benefits

 

 

3,933,441

 

 

1,526,794

 

 

743,212

 

Share   based compensation

 

 

232,048

 

 

65,842

 

 

—  

 

Technology

 

 

269,254

 

 

196,151

 

 

52,850

 

Restructuring

 

 

538,019

 

 

—  

 

 

—  

 

General   and administrative

 

 

4,926,136

 

 

1,646,716

 

 

732,577

 

 

 

 

 

 

**Total   operating expenses**

 

 

14,551,384

 

 

6,927,159

 

 

3,456,475

 

 

 

 

 

 

**Operating   income (loss)**

 

 

(4,391,388

)

 

(642,120

)

 

219,856

 

**Other   income (expense):**

 

 

 

 

 

 

 

 

 

 

Interest   income

 

 

155,701

 

 

178,676

 

 

1,205

 

Interest   expense

 

 

(608,013

)

 

(853

)

 

—  

 

Gain   on early extinguishment of debt

 

 

1,500,000

 

 

—  

 

 

—  

 

 

 

 

 

 

**Income (loss) before provision for income taxes**

 

 

(3,343,700

)

 

(464,297

)

 

221,061

 

Provision for income taxes

 

 

—  

 

 

28,000

 

 

—  

 

 

 

 

 

 

**Net income   (loss)**

 

$

(3,343,700

)

$

(492,297

)

$

221,061

 

 

 

 

 

 

**Earnings   (loss) per common share:**

 

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.62

)

$

(0.13

)

$

0.10

 

Diluted

 

$

(0.62

)

$

(0.13

)

$

0.07

 

**Weighted   average common shares outstanding:**

 

 

 

 

 

 

 

 

 

 

Basic

 

 

5,419,872

 

 

3,667,913

 

 

2,285,382

 

Diluted

 

 

6,106,369

 

 

4,142,075

 

 

2,999,169

 

The accompanying notes are an integral part of these consolidated financialstatements.

F-5

**BabyUniverse, Inc. and Subsidiaries ConsolidatedStatements of Stockholders’ Equity (Deficit)**

**Description**

 

**Shares**

 

**Amount**

 

**Additional Paid in   Capital**

 

**Unearned   Compensation**

 

**Accumulated   Deficit**

 

**Total**

 

 

 

 

 

 

 

 

**December   31, 2003**

 

 

2,284,934

 

 

2,285

 

 

1,935,756

 

 

—  

 

 

(2,627,599

)

 

(689,558

)

 

 

 

 

 

 

 

 

Exercise of warrants

 

 

54,682

 

 

55

 

 

2,106

 

 

—  

 

 

—  

 

 

2,161

 

Net income - 2004

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

221,061

 

 

221,061

 

 

 

 

 

 

 

 

 

**December   31, 2004**

 

 

2,339,616

 

 

2,340

 

 

1,937,862

 

 

—  

 

 

(2,406,538

)

 

(466,336

)

 

 

 

 

 

 

 

 

Exercise of stock options

 

 

688,446

 

 

687

 

 

201,411

 

 

—  

 

 

—  

 

 

202,098

 

Exercise of warrants

 

 

36,476

 

 

37

 

 

1,285

 

 

—  

 

 

—  

 

 

1,322

 

Grant of restricted stock

 

 

7,500

 

 

8

 

 

619,518

 

 

(553,684

)

 

—  

 

 

65,842

 

Initial public offering of   common stock

 

 

2,000,000

 

 

2,000

 

 

16,341,101

 

 

—  

 

 

—  

 

 

16,343,101

 

Issuance of common stock -   Dreamtime Baby acquisition

 

 

53,165

 

 

53

 

 

491,192

 

 

—  

 

 

—  

 

 

491,245

 

Net loss - 2005

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

(492,297

)

 

(492,297

)

 

 

 

 

 

 

 

 

**December   31, 2005**

 

 

5,125,203

 

$

5,125

 

$

19,592,369

 

$

(553,684

)

$

(2,898,835

)

$

16,144,975

 

 

 

 

 

 

 

 

 

Reclassification of unearned   compensation according to FAS123(R)

 

 

—  

 

 

—  

 

 

(553,684

)

 

553,684

 

 

—  

 

 

—  

 

Initial public offering   expenses

 

 

—  

 

 

—  

 

 

(14,742

)

 

—  

 

 

—  

 

 

(14,742

)

Issuance of common stock -   Posh Tots acquisition

 

 

237,248

 

 

237

 

 

2,013,999

 

 

—  

 

 

—  

 

 

2,014,236

 

Issuance of warrants - Posh   Tots acquisition

 

 

—  

 

 

—  

 

 

361,548

 

 

—  

 

 

—  

 

 

361,548

 

Share based compensation for   employee stock options

 

 

—  

 

 

—  

 

 

130,007

 

 

—  

 

 

—  

 

 

130,007

 

Vesting of  restricted stock

 

 

60,167

 

 

60

 

 

101,981

 

 

—  

 

 

—  

 

 

102,041

 

Issuance of warrants -   Hercules Financing

 

 

—  

 

 

—  

 

 

322,231

 

 

—  

 

 

—  

 

 

322,231

 

Issuance of common stock for cash

 

 

263,852

 

 

264

 

 

1,989,480

 

 

—  

 

 

—  

 

 

1,989,744

 

Net loss- 2006

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

 

(3,343,700

)

 

(3,343,700

)

 

 

 

 

 

 

 

 

**December   31, 2006**

 

 

5,686,470

 

 

5,686

 

 

23,943,189

 

 

—  

 

 

(6,242,535

)

 

17,706,340

 

 

 

 

 

 

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

F-6

**BabyUniverse, Inc. and Subsidiaries Consolidated Statements of Cash Flows**

 

 

**Year Ended   December 31,**

 

 

 

 

 

 

**2006**

 

**2005**

 

**2004**

 

 

 

 

 

 

**Operating   activities:**

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(3,343,700

)

$

(492,297

)

$

221,061

 

Adjustments to reconcile net   income (loss) to net cash provided by (used in) operating activities:

 

 

 

 

 

 

 

 

 

 

Depreciation   and amortization

 

 

596,770

 

 

110,750

 

 

48,133

 

Share-based   compensation

 

 

232,048

 

 

65,842

 

 

—  

 

Gain on early exstinguishment of debt

 

 

(1,500,000

)

 

—  

 

 

—  

 

Amortization   of prepaid finance costs

 

 

132,616

 

 

8,061

 

 

—  

 

Changes in operating assets   and liabilities:

 

 

 

 

 

 

 

 

 

 

(Increase)   decrease in accounts receivable

 

 

43,892

 

 

(160,362

)

 

(57,726

)

(Increase)   decrease in inventory

 

 

(704,710

)

 

(630,279

)

 

(257,281

)

(Increase)   decrease in prepaid expenses

 

 

(55,925

)

 

(170,920

)

 

(78,852

)

(Increase)   in deposits

 

 

(88,587

)

 

(27,918

)

 

(17,726

)

Increase   in accounts payable

 

 

1,997,224

 

 

838,578

 

 

665,658

 

Increase   in accrued expenses

 

 

(181,859

)

 

454,501

 

 

—  

 

Increase   (decrease) in gift certificate liability

 

 

15,550

 

 

14,254

 

 

12,620

 

(Decrease)   in deferred revenue

 

 

(264,989

)

 

(48,065

)

 

57,626

 

Increase   in deferred rent

 

 

173,999

 

 

15,543

 

 

4,999

 

 

 

 

 

 

**Net cash   provided by (used in) operating activities:**

 

 

(2,947,671

)

 

(22,312

)

 

598,512

 

 

 

 

 

 

**Investing   activities:**

 

 

 

 

 

 

 

 

 

 

Purchase of fixed assets

 

 

(1,572,776

)

 

(509,070

)

 

(210,403

)

Cash paid in acquisition,   net of cash received

 

 

(6,017,419

)

 

(6,623,443

)

 

—  

 

Purchase of intangible   assets

 

 

(184,257

)

 

—  

 

 

—  

 

Cash received from purchase   price adjustment

 

 

300,000

 

 

—  

 

 

—  

 

 

 

 

 

 

**Net cash   used in investing activities:**

 

 

(7,474,452

)

 

(7,132,513

)

 

(210,403

)

 

 

 

 

 

**Financing   activities:**

 

 

 

 

 

 

 

 

 

 

Proceeds from exercise of   options

 

 

—  

 

 

202,098

 

 

—  

 

Proceeds from exercise of   warrants

 

 

—  

 

 

1,321

 

 

2,160

 

Proceeds from (costs associated with)  initial public   offering of common stock, net

 

 

(14,742

)

 

16,343,101

 

 

—  

 

Repayment of employee loans

 

 

—  

 

 

(79,124

)

 

—  

 

Repayment of note for Posh   Tots purchase

 

 

(4,500,000

)

 

—  

 

 

—  

 

Proceeds from Hercules   Technology financing

 

 

5,000,000

 

 

—  

 

 

—  

 

Costs of Hercules Technology   financing

 

 

(473,463

)

 

—  

 

 

—  

 

Proceeds from Lydian Bank   financing, nets

 

 

1,974,050

 

 

—  

 

 

—  

 

Proceeds from issuance of common stock, net

 

 

1,989,744

 

 

—  

 

 

—  

 

 

 

 

 

 

**Net cash   provided by financing activities:**

 

 

3,969,595

 

 

16,467,396

 

 

2,160

 

 

 

 

 

 

Net (decrease) increase in   Cash

 

 

(6,452,528

)

 

9,312,571

 

 

390,269

 

Beginning Cash

 

 

9,925,806

 

 

613,235

 

 

222,966

 

 

 

 

 

 

Ending Cash

 

$

3,473,278

 

$

9,925,806

 

$

613,235

 

 

 

 

 

 

The accompanying notes are an integral part of these consolidated financialstatements.

F-7

**BabyUniverse, Inc. and SubsidiariesNotes toConsolidated Financial Statements**

**Note 1 — Description of the Company and Summary of SignificantAccounting Policies**

***The Company***** **

          BabyUniverse, Inc.(the “Company’’) is a leading Internet content, commerce and newmedia company in the pregnancy, baby and toddler marketplace. Through its Websites, BabyUniverse.com and DreamtimeBaby.com, the Company is a leading onlineretailer of brand-name baby, toddler and maternity products in the UnitedStates. Through its Web sites PoshTots.com and PoshLiving.com, the Company hasextended its offerings in the baby and toddler market as a leading onlineprovider of luxury furnishings to the country’s most affluent femaleconsumers. Through PoshCravings.com, ePregnancy.com and the recently-introduced,BabyTV.com, the Company has also established a widely recognized platform forthe delivery of content and new media resources to a national audience ofexpectant parents. 

          The Company wasincorporated on October 15, 1997 under the laws of the State of Florida asEverything But The Baby, Inc.  On November 16, 2001 the Board of Directorschanged the name of the corporation to BabyUniverse, Inc. Customer purchases areshipped directly from the Company’s warehouses, or are drop shippeddirectly to customers from the Company’s suppliers.  The Companyoperates on a calendar year basis.

          On September 13,2005 the Company acquired 100% of the outstanding capital stock of Huta Duna,Inc., d/b/a DreamtimeBaby.com (“Dreamtime Baby”). The results ofDreamtime Baby’s operations have been included in the consolidatedfinancial statements of the Company since that date.  

          On January 13, 2006the Company acquired, through a newly-created wholly-owned subsidiary,substantially all of the assets of PoshTots, LLC, a luxury online retailer ofbaby and children’s furnishings.  Through its primary website,www.PoshTots.com, the Richmond-based PoshTots, LLC has long been recognized as aleading online retailer of high-end, artisan-crafted furniture to thiscountry’s most affluent new mothers.  Beyond the baby andchildren’s segments, PoshTots recently extended its brand with the Fall2005 introduction of a new website, www.PoshLiving.com, offering designerquality home furnishings to its existing and growing base of affluent,predominantly female, customers. In March 2006, Posh Tots introduced another newwebsite, www.PoshCravings.com, designed as a content driven initiative targetedat the affluent female customer base already developed by Posh Tots.

***Principles of Consolidation***

          The Company’sconsolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America(“GAAP”) and include the accounts of the Company and its wholly-ownedsubsidiaries. All material inter-company transactions and balances have beeneliminated in consolidation. 

***Reclassifications***

          Certain accountbalances in the prior year have been reclassified to permit comparison with thecurrent year. 

***Use of Estimates***

          Our consolidatedfinancial statements have been prepared in accordance with GAAP.  Thepreparation of these financial statements requires estimates and assumptionsthat affect the reported amounts of assets and liabilities, revenues andexpenses, and related disclosures of contingent assets and liabilities in theconsolidated financial statements and accompanying notes.  The Companybases its estimates on historical experience and on other assumptions that itbelieves to be reasonable under the circumstances.  However, estimatesinherently relate to matters that are uncertain at the time the estimates aremade, and are based upon information presently available.  Actual resultsmay differ significantly from these estimates under different assumptions,judgments, or conditions.

***Concentration of Credit Risk***

          The Company’sfinancial instruments that are exposed to concentration of credit risk are cash.Additionally, the Company maintains cash balances in bank deposit and moneymarket accounts that, at times, may exceed federally insured limits.

F-8

***Cash***

          The Companyconsiders cash in banks, commercial paper and other highly liquid investmentswith insignificant interest rate risk and maturities of three months or less atthe time of acquisition to be cash and cash equivalents.  TheCompany’s cash balance as of December 31, 2006 includes $260,000 held by acommercial bank in a certificate of deposit in support of the bank’s$250,000 purchase card credit facility extended to the Company. At December 31,2006, the Company had cash of approximately $3.5 million.

***Accounts Receivable***

          The Company’saccounts receivable consist primarily of cash due from credit card companies fororders fulfilled prior to the receipt of funds. No allowance for doubtfulaccounts has been provided as of December 31, 2006 or 2005.

***Inventory***

          Inventory, whichconsists primarily of car seats, strollers, bedding, baby toys, learning toolsand other small items available for sale, is accounted for using the first-infirst-out (“FIFO”) method, and is valued at the lower of cost ormarket value. This valuation requires the Company to make judgments, based oncurrently-available information, about the likely method of disposition, such assales to individual customers, returns to product vendors, or liquidations, andexpected recoverable values of each method of disposition. As of December 31,2006, the Company has provided a reserve for inventory obsolescence of $49,000.There was no reserve for obsolescence at December 31, 2005. 

***Prepaid Expenses***

          Prepaid expensesinclude amounts paid in advance for Directors and Officers liability insurance,acquisition costs and public offering costs.  

***Fixed Assets***

          Fixed assets arestated at historical cost. Depreciation and amortization are computed using thestraight line method over the estimated useful life of the asset. Leaseholdimprovements are amortized over the term of their estimated useful lives or therelated leases, whichever is shorter. 

          The Companycapitalizes certain costs incurred in connection with the development of orobtaining internal use software in accordance with Statement of Position(SOP) 98-1, *Accounting for the Costs of Computer Software Developed orObtained for Internal Use*, and Emerging Issues Task Force (“EITF”)00-2, *Accounting for Web Site Development Costs*.

***Long-Lived Assets***

          The Company reviewsits long-lived assets for impairment whenever events or changes in circumstancesindicate that the carrying amount of the asset may not be recovered. The Companylooks primarily to the undiscounted future cash flows in its assessment ofwhether or not long-lived assets have been impaired. At December 31, 2006and December 31, 2005 the Company determined there was no impairment.

***Deposits***

          Deposits consist ofsecurity deposits for the lease of the Company’s office and warehousefacilities. 

***Goodwill*** 

          SFAS No. 141,*Business Combinations*, requires that all business combinations beaccounted for using the purchase method of accounting and that certainintangible assets acquired in a business combination be recognized as assetsseparate from goodwill. Goodwill is not subject to amortization and is testedfor impairment annually or more frequently if events or changes in circumstancesindicate that the asset may be impaired in accordance with SFAS No. 142,*Goodwill and Other Intangible Assets.* The impairment test consists of acomparison of the fair value of the reporting unit with its carryingamount.  If the carrying amount of the reporting unit exceeds its fairvalue, then an analysis will be performed to compare the implied fair value withthe carrying amount of goodwill. An impairment loss would be recognized in anamount equal to the difference. Fair value is generally based upon future cashflows discounted at a rate that reflects the risk involved or market-basedcomparables. After an impairment loss is recognized, the adjusted carryingamount of goodwill becomes its new accounting basis.  

F-9

***Gift Certificate Liability***

          The Company sellsgift certificates to be exchanged for merchandise at the discretion of thecertificate holder. Management has determined that certificates over one yearold, generally, are not redeemed.  Certificates of less than one year arerecorded as a current liability on the Company’s Consolidated BalanceSheet. Based on historical data, Management has determined that the dollar valueof certificates redeemed, whose age is greater than one year, is immaterial tototal revenue. 

***Deferred Revenue***

          Deferred revenuerepresents payments received from customers before products areshipped.

***Revenue Recognition***

          The Company hasadopted SEC *Staff Accounting Bulletin (SAB) No. 101 —Revenue Recognition*, which defines that revenue is both earned andrealizable when the following four conditions are met: 

 

•

Pervasive evidence of an   arrangement exists

 

•

The selling price is fixed   or determinable

 

•

Delivery or performance   has occurred

 

•

Collectibility is   reasonably assured

          Per SEC *StaffAccounting Bulletin (SAB) No. 104*, which further clarifiesSAB No. 101, if merchandise is shipped to customers F.O.B. ShippingPoint, title is considered to have transferred to the customer at the time themerchandise is delivered to the carrier. The Company’s policy is to shipF.O.B. Shipping Point from its warehouses and drop ship locations, and thereforedelivery is deemed to have occurred at time of shipment. 

          The Company has alsoadopted *EITF 99-19, Reporting Revenue Gross as a Principal versus Net asan Agent*, as its formal guidelines for the recognition of revenue in itsfinancial statements. All sales are completed through the Company and liabilityfor product purchases is paid by the Company. Therefore, the Company recognizesthe gross sales price as its revenue at the time that the product is deliveredto the carrier.

          Return allowances,which reduce product revenue, are estimated using historical experience.

***Cost of Goods Sold ***

          Cost of goods soldconsists of the purchase price of the Company’s products that were sold,inbound and outbound shipping costs, and purchase discounts and credits that theCompany earned. 

***Advertising ***

          The Company’smarketing consists primarily of online advertising with a number of Internetproviders, which includes portal advertising, search engine marketing and otherprograms designed to educate customers about the Company’s brands andproducts. All advertising costs are expensed as incurred. 

***Technology ***

          Technology costs areexpensed as incurred, except in those circumstances where the costs are relatedto the development of internal use software and website development.  PerSOP 98-1 these costs are capitalized and depreciated over a 5-year period.During 2006, 2005 and 2004 the Company capitalized costs of approximately$205,388, $168,000 and $172,000, respectively. 

***Share-Based Compensation***

          Effective with theCompany’s current fiscal year that began on January 1, 2006, the Companyadopted the accounting and disclosure provisions of Statement of FinancialAccounting Standard SFAS No. 123(R), *Share-Based Payment*, whichrequires that new, modified and unvested share based payment transactions withemployees, such as stock options and restricted stock, be measured at fair valueand recognized as compensation expense over the vesting period. 

F-10

          The Company adoptedSFAS No. 123(R) using the modified prospective application transitionmethod.  Under that transition method, compensation cost is recognized onor after the required effective date for the portion of outstanding awards atthe date of adoption, for which the requisite service has not yet been rendered,based on the grant-date fair value of those awards calculated underSFAS No. 123, *Accounting for Stock-Based Compensation*, foreither recognition or pro forma disclosures.  As part of adopting themodified prospective approach during the transitional period, the Companyconsidered the determination of a one-time cumulative effect adjustment for theportion of stock options granted prior to January 1, 2006 that had notvested.  However, as of January 1, 2006, no cumulative effect adjustmentwas required, because the requisite service had previously been fully renderedfor outstanding awards, and because the Company accounted for the Plan underAccounting Principles Board (“APB”) Opinion No. 25, *Accountingfor Stock Issued to Employees*, instead of SFAS No. 123.

          Prior to January 1,2006, the Company had accounted for the Plan under APB Opinion No. 25 andits related interpretations, and adopted the disclosure provisions ofSFAS No. 123, as amended by SFAS No. 148, *Accounting ForStock-Based Compensation* - *Transition and Disclosure*.  SFAS No.123 defines a fair value method of accounting for issuance of stock options andother equity instruments. Under the fair value method, compensation cost ismeasured at the grant date based on the fair value of the award and isrecognized over the service period, which is usually the vesting period.Pursuant to SFAS No. 123, companies were encouraged, but not required to adoptthe fair value method of accounting for employee stock based transactions.Companies were also permitted to continue to account for such transactions underAccounting Principles Board Opinion (APB) No. 25, *Accounting for Stock Issuedto Employees,*but were required to disclose in a note to the financialstatements pro forma results as if the Company had applied SFAS No.123.

          At December 31,2005, the Company had a fixed stock option plan. The Company applied APB OpinionNo. 25 and related Interpretations in accounting for its plan. Had compensationcost for the Company’s stock option plan been determined based on the fairvalue at the grant dates for awards under that plan consistent with the methodof SFAS No. 123, the Company’s net income (loss) and earnings (loss) pershare would have been reduced to the pro forma amounts indicatedbelow:

 

 

**Year Ended   December 31,**

 

 

 

 

 

 

**2006**

 

**2005**

 

**2004**

 

 

 

 

 

 

Net income (loss), as   reported

 

$

(3,343,700

)

$

(492,297

)

$

221,061

 

Add:  Stock-based compensation expense, as   reported

 

 

232,048

 

 

65,842

 

 

—  

 

Deduct:  Stock-based compensation expense determined under fair-value-basedmethod, net of tax

 

 

(232,048

)

 

(88,858

)

 

(22,216

)

 

 

 

 

 

Pro forma net income (loss)

 

$

(3,343,700

)

$

(515,313

)

$

198,845

 

 

 

 

 

 

Earnings (loss) per share

 

 

 

 

 

 

 

 

 

 

Basic - as reported

 

$

(0.62

)

$

(0.13

)

$

0.10

 

Basic - pro forma

 

$

(0.62

)

$

(0.13

)

$

0.09

 

Diluted - as reported

 

 

 

 

 

 

 

$

0.07

 

Diluted - pro forma

 

 

 

 

 

 

 

$

0.07

 

          For purposes of thepro forma disclosure above, the fair value of each option grant was estimated onthe date of grant using the Minimum Value method prescribed for use bynon-public companies pursuant to SFAS No. 123. The followingassumptions were used in applying the Minimum Value method for 2004: no dividendyield; no volatility factor; risk-free interest rates for that ranged between3.05% and 3.14%; and expected lives using the “simplified method”permitted by the SEC’s Staff Accounting Bulletin 107, issuedMarch 29, 2005. For 2006 and  2005, the Company used an acceptablevaluation method prescribed for use by public companies pursuant to SFAS No.123. The following assumptions were used in 2006 and 2005, respectively,applying the fair value method: no dividend yield; volatility factor of 56% and70%; risk-free interest rates that ranged between 3.69% and 4.46%; and expectedlives using the “simplified method” permitted by the SEC’s StaffAccounting Bulletin 107.

          During the initialphase-in period, the effects of applying this SFAS No. 123 for thepurpose of disclosing the pro forma effect on net income (loss) and earnings(loss) per share as reported are not likely to be representative of the effectson reported net income (loss) for future years, because options vest overseveral years and additional awards are generally made each year, and becausethe Company no longer used the Minimum Value method after 2004.

F-11

          The Company’s2001 Stock Award Plan was amended in April 2005 by our board of directors andshareholders and was renamed the “BabyUniverse 2005 Stock IncentivePlan.” Under the Stock Incentive Plan, the exercise price of each optionequals the market price of the stock on the date of grant, the vesting periodgenerally ranges between two and five years, and an option’s maximum termis 10 years. 

          On April 27, 2005,the Board of Directors approved the acceleration of vesting of all unvestedoptions. A total of 208,496 stock options with an average exercise price of $2.60 and an average remaining contractual life of 18 months were subject toacceleration. The exercise price and number of shares subject to accelerationwere unchanged.

          As of December 31,2006, an aggregate of 405,289 shares of common stock are reserved forissuance under the 2005 Stock Incentive Plan. Restricted stock grants and stockoption grants were outstanding for an aggregate of 234,054 shares of stock,and 171,235 shares remained available for grant. In addition, there wereoutstanding options to purchase a total of 104,248 shares of our commonstock, and 20,000 shares of restricted stock, which were granted outside of the2005 Stock Incentive Plan.  Shares issued pursuant to the Stock IncentivePlan will be newly-issued and authorized shares of common stock, or treasuryshares. 

***Income Taxes***

          The FinancialAccounting Standards Board (FASB) issued Statements of Financial AccountingStandards (SFAS) No. 109, *Accounting for Income Taxes*, whichrequires companies to use the asset and liability method of accounting forincome taxes. Under the asset and liability method, deferred income taxes arerecognized for the tax consequence of temporary differences by applying enactedstatutory tax rates applicable to future year’s differences between thefinancial statements carrying amounts and the tax basis of existing assets andliabilities. Pursuant to SFAS No. 109, the effect on deferred taxes ofa change in tax rates is recognized in income in the period that includes theenactment date. Under the deferred method, deferred taxes were recognized usingthe tax applicable to the year of the calculation and were not adjusted forsubsequent changes in tax rates. 

F-12

***Earnings (Loss) per Share ***

          The Company computesearnings (loss) per share in accordance with the provisions ofSFAS No. 128, *Earnings per Share*. Under the provisions of SFASNo. 128, basic earnings per share (EPS) is computed by dividing the netearnings (loss) from operations for the period by the weighted average number ofcommon shares outstanding for the period. Diluted EPS reflects the potentialdilution that could occur from common stock issuable through stock basedcompensation including stock options, restricted stock awards, warrants andother convertible securities. 

          For years endingDecember 31, 2006 and 2005 the Company reported a net loss. The dilutedearnings per share is not presented for those periods since the effect isantidilutive. 

***Fair Value of Financial Instruments***

          The carrying amountsof financial instruments including cash, accounts receivable, accounts payableand accrued expenses approximate fair value as of December 31, 2006 and2005, as a result of the relatively short maturity of these instruments. Notesand capital leases are reflected at fair value and are recorded net of theunamortized discount.

***Recently Issued Accounting Standards***

          In February 2006,the FASB issued SFAS No. 155, *Accounting for Certain Hybrid FinancialInstruments—an amendment of FASB Statements No. 133 and 140.*  ThisStatement amends FASB Statements No. 133, *Accounting for DerivativeInstruments and Hedging Activities,* and No. 140, *Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities.* This Statement resolves issues addressed in Statement 133 Implementation IssueNo. D1, “Application of Statement 133 to Beneficial Interests inSecuritized Financial Assets.”  This Statement:

 

a.

Permits fair value remeasurement for any hybrid financial instrument thatcontains an embedded derivative that otherwise would requirebifurcation

 

b.

Clarifies which interest-only strips and principal-only strips are not subjectto the requirements of Statement 133

 

c.

Establishes a requirement to evaluate interests in securitized financial assetsto identify interests that are freestanding derivatives or that are hybridfinancial instruments that contain an embedded derivative requiringbifurcation

 

d.

Clarifies that concentrations of credit risk in the form of subordination arenot embedded derivatives

 

e.

Amends Statement 140 to eliminate the prohibition on a qualifyingspecial-purpose entity from holding a derivative financial instrument thatpertains to a beneficial interest other than another derivative financialinstrument.

          This Statement iseffective for all financial instruments acquired or issued after the beginningof an entity’s first fiscal year that begins after September 15,2006.  Management does not expect adoption of SFAS No. 155 to have amaterial impact, if any, on the Company’s financial position or results ofoperations. 

          In March 2006, theFASB issued SFAS No. 156, *Accounting for Servicing of Financial Assets anamendment of FASB Statement No. 140*.  This Statement amends FASBStatement No. 140, *Accounting for Transfers and Servicing of Financial Assetsand Extinguishments of Liabilities*, with respect to the accounting forseparately recognized servicing assets and servicing liabilities.  ThisStatement:

 

a.

Requires an entity to recognize a servicing asset or servicing liability eachtime it undertakes an obligation to service a financial asset by entering into aservicing contract.

 

b.

Requires all separately recognized servicing assets and servicing liabilities tobe initially measured at fair value, if practicable.

 

c.

Permits an entity to choose either the amortization method or the fair valuemeasurement method for subsequent measurement for each class of separatelyrecognized servicing assets and liabilities.

 

d.

At its initial adoption, permits a one-time reclassification ofavailable-for-sale securities to trading securities by entities with recognizedservicing rights, without calling into question the treatment of otheravailable-for-sale securities under Statement No. 115.

 

e.

Requires separate presentation of servicing assets and liabilities subsequentlymeasured at fair value in the statement of financial position and additionaldisclosures.

F-13

          An entity shouldadopt this Statement as of the beginning of its first fiscal year that beginsafter September 15, 2006.  Earlier adoption is permitted as of thebeginning of an entity’s fiscal year, provided the entity has not yetissued financial statements, including interim financial statements, for anyperiod of that fiscal year. The effective date of this Statement is the date anentity adopts the requirements of this Statement.  The adoption of thisstatement is not expected to have a material impact on the Company’sconsolidated financial statements. 

          In June 2006, theEmerging Issues Task Force (“EITF”) issued EITF 06-3, “How TaxesCollected from Customers and Remitted to Governmental Authorities Should BePresented in the income statement (That is, Gross versus Net Presentation)”to clarify diversity in practice on the presentation of different types of taxesin the financial statements. The Task Force concluded that, for taxes within thescope of the issue, a company may adopt a policy of presenting taxes eithergross within revenue or net. That is, it may include charges to customers fortaxes within revenues and the charge for the taxes from the taxing authoritywithin cost of sales, or, alternatively, it may net the charge to the customerand the charge from the taxing authority. If taxes subject to EITF 06-3 aresignificant, a company is required to disclose its accounting policy forpresenting taxes and the amounts of such taxes that are recognized on a grossbasis. The guidance in this consensus is effective for the first interimreporting period beginning after December 15, 2006 (the first quarter of ourfiscal year 2007). We do not expect the adoption of EITF 06-3 will have amaterial impact on our consolidated results of operations, financial position orcash flow.

          In July 2006, theFASB issued Interpretation No. 48, *Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109.*  ThisInterpretation clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with FASBStatement No. 109, *Accounting for Income Taxes.*  This Interpretationprescribes a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return.  This Interpretation also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition.  This Interpretation is effective forfiscal years beginning after December 15, 2006.  Earlier application of theprovisions of this Interpretation is encouraged if the enterprise has not yetissued financial statements, including interim financial statements, in theperiod this Interpretation is adopted.  Management does not expect adoptionof Interpretation No. 48 to have a material impact, if any, on theCompany’s consolidated financial position or results of operations.

          In September 2006,the FASB issued SFAS No. 157, *Fair Value Measurements*, which defines thefair value, establishes a framework for measuring fair value and expandsdisclosures about fair value measurements. This statement is effective forfinancial statements issued for fiscal years beginning after November 15, 2007,and interim periods within those fiscal years. Early adoption is encouraged,provided that we have not yet issued financial statements for that fiscal year,including any financial statements for an interim period within that fiscalyear. We are currently evaluating the impact SFAS 157 may have on ourconsolidated financial condition or results of operations. 

          In September 2006,the United States Securities and Exchange Commission (SEC) issued StaffAccounting Bulletin No. 108, *Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements* (“SAB 108”). This SAB provides guidance on theconsideration of the effects of prior year misstatements in quantifying currentyear misstatements for the purpose of a materiality assessment. SAB 108establishes an approach that requires quantification of financial statementerrors based on the effects of each of the company’s balance sheet andstatement of operations and the related financial statement disclosures. The SABpermits existing public companies to record the cumulative effect of initiallyapplying this approach in the first year ending after November 15, 2006 byrecording the necessary correcting adjustments to the carrying values of assetsand liabilities as of the beginning of that year with the offsetting adjustmentrecorded to the opening balance of retained earnings. Additionally, the use ofthe cumulative effect transition method requires detailed disclosure of thenature and amount of each individual error being corrected through thecumulative adjustment and how and when it arose. We are currently evaluating theimpact SAB 108 may have to our consolidated financial condition or results ofoperations. 

F-14

          In September 2006,the FASB issued SFAS No. 158, Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans—an amendment of FASB Statements No.87, 88, 106, and 132(R). This Statement improves financial reporting byrequiring an employer to recognize the overfunded or underfunded status of adefined benefit postretirement plan (other than a multiemployer plan) as anasset or liability in its statement of financial position and to recognizechanges in that funded status in the year in which the changes occur throughcomprehensive income of a business entity or changes in unrestricted net assetsof a not-for-profit organization. This Statement also improves financialreporting by requiring an employer to measure the funded status of a plan as ofthe date of its year-end statement of financial position, with limitedexceptions.* *An employer with publicly traded equity securities isrequired to initially recognize the funded status of a defined benefitpostretirement plan and to provide the required disclosures as of the end of thefiscal year ending after December 15, 2006.  Earlier application of therecognition or measurement date provisions is encouraged; however, earlyapplication must be for all of an employer’s benefit plans. Retrospectiveapplication of this Statement is not permitted.  Management does not expectadoption of SFAS No. 158 to have a material impact, if any, on theCompany’s consolidated financial position or results ofoperations.* *

**Note 2 — Acquisitions**

***ePregnancy***

          On June 15, 2006,the Company acquired certain assets related specifically to the business ofePregnancy.com and ePregnancy Magazine.  The selected assets acquiredinclude the URL www.ePregnancy.com, the ePregnancy trademark, a related onlinecommunity website, message boards, and an expansive archive of content. The magazine’s prior owners discontinued publication of ePregnancy Magazineand the final published issue was distributed in late April as the May 2006issue.  BabyUniverse intends to focus its efforts on growing and supportingthe online community at ePregnancy.com and does not intend to revive themagazine. 

          Therevenue-producing activity of the business component did not exist at the timeselected assets were acquired by the Company.  In addition, none of thefollowing attributes were included among the selected assets acquired by theCompany: physical facilities, employee base, sales force or productiontechniques.  As a result of these facts, the Company has accounted for theePregnancy transaction as an acquisition of selected assets, and not as theacquisition of a business, consistent with guidance provided in Rule 11-01 (d)of Regulation S-X of the Securities and Exchange Commission.  

***Posh Tots***

          On January 13, 2006BabyUniverse completed an acquisition of substantially all of the assets of PoshTots, LLC (“Posh Tots”).  The acquisition was consummatedpursuant to the terms and provisions of an Asset Purchase Agreement dated as ofJanuary 13, 2006 by and between Posh Tots, Inc., a wholly owned subsidiary ofthe Company, and Posh Tots. 

          In connection withthe acquisition, the Company issued a promissory note, as adjusted, of$5,570,981, and paid $6,000,000 in cash.  In addition, the Company issued237,248 shares of the Company’s common stock and warrants to purchase110,000 shares of common stock.  The shares were valued at the date ofacquisition and resulted in a value of $2,014,236.  The warrants areexercisable at $8.10 per share, have a contractual life of two years, and vestone year following the acquisition date.  The warrants were valued at$300,753 using the Black-Scholes option pricing model with the followingassumptions: a risk-free interest rate of 4.23%, a volatility factor of 56%, andan expected term of two years.  

          Approximately$600,000 of the purchase price, related to repayment of the promissory note, wasdeposited into an escrow fund to secure possible claims related to therepresentations and warranties.  The escrow fund was subsequentlydistributed to the seller in August 2006, net of a post-closing working capitaladjustment pursuant to the agreement. The difference between the purchaseprice and the fair value of the acquired net assets of Posh Tots of $12,071,917was recorded as goodwill.   

          The following tablesummarizes the estimated fair values of the assets acquired and liabilitiesassumed at the date of acquisition, January 13, 2006:  

Current assets

 

$

516,464

 

Property and equipment

 

 

60,974

 

Intangible assets

 

 

2,660,000

 

Goodwill

 

 

12,071,917

 

 

 

 

Total assets acquired

 

 

15,309,355

 

Current liabilities assumed

 

 

(934,546

)

 

 

 

Net assets acquired

 

$

14,374,809

 

 

 

 

F-15

          Of the $2,660,000 ofacquired intangible assets, $2,200,000 was assigned to the Posh Tots trade namethat has an indefinite life, $200,000 was assigned to customer list that has auseful life of 4 years, and $260,000 was assigned to catalogue and websitecontent that has a useful life of 3 years.  

          The accompanyingunaudited pro forma summary represents consolidated results of operations forBabyUniverse as if the acquisition of Posh Tots had been consummated on January1, 2005.  Certain pro forma adjustments were reflected in the consolidatedresults of operations as follows:

 

1.

To reflect members’ salaries on a “going-forward” basis as agreedto in employment contracts entered into by Posh Tots, Inc. and three formermembers of Posh Tots, LLC.  The employment contracts specify annualcash-based compensation of $360,000.  The adjustment decreased actualmembers’ salaries to the contracted amounts.

 

 

 

 

2.

To reflect the accumulated amortization and related amortization expense ofcertain intangible assets that were created in connection with the acquisitionof Posh Tots assets.

 

 

 

 

3.

The federal income tax effect has been omitted because BabyUniverse believes itcan apply its net operating loss carryforwards to profits generated. However, the pro forma income of Posh Tots, LLC would be subject to Virginiastate income tax.  BabyUniverse’s Florida state net operating losscarryforwards would not be applicable to Virginia state income.  Theapplicable 2005 Virginia state tax rate of six percent has been applied to theVirginia pro forma income.

          The pro formainformation does not necessarily reflect the actual results that would have beenachieved, nor is it necessarily indicative of future consolidated results of theCompany. 

 

 

**Year Ended   December 31, 2005**

 

 

 

 

 

 

**Pro Forma**

 

**As   Reported**

 

 

 

 

 

Net sales

 

$

29,981,753

 

$

23,702,455

 

Net loss

 

$

(153,858

)

$

(492,297

)

Earnings per share:

 

 

 

 

 

 

 

Basic

 

$

(0.04

)

$

(0.13

)

Diluted

 

$

(0.04

)

$

(0.13

)

Weighted average shares   outstanding:

 

 

 

 

 

 

 

Basic

 

 

3,905,161

 

 

3,667,913

 

Diluted

 

 

4,489,323

 

 

4,142,075

 

***DreamtimeBaby.com***

          On September13, 2005 BabyUniverse, Inc. acquired 100 percent of the outstanding commonshares of privately-held Huta Duna, Inc.  The results of Huta Duna,Inc.’s operations have been included in the consolidated financialstatements of the Company since that date.  Huta Duna, Inc. operates ane-commerce web site, DreamTimeBaby.com, an online retailer of brand name babyproducts.  Dreamtime Baby offers a broad selection of baby products, but itis primarily recognized for its focus on high quality baby beddingproducts.  As a result of the acquisition, BabyUniverse expects to benefitfrom Dreamtime Baby’s strong internet marketing practices and strongsupplier relationships.  BabyUniverse also expects to reduce purchasing andshipping costs through economies of scale.

          The aggregatepurchase price paid by BabyUniverse, inclusive of closing costs of approximately$206,226, was $7,096,871, including $6,399,400 of cash and 53,165 shares ofBabyUniverse common stock with a fair value of $491,245.  The fair value ofthe 53,165 common shares issued was determined based on the 15-day closing priceof BabyUniverse’s common stock as reported by the American Stock Exchangefor the seven days prior to, the day of and the seven days following theacquisition date, which date coincided with the agreement and announcement ofthe transaction.  Approximately $650,000 of the purchase price wasdeposited into an escrow fund to secure possible claims related to therepresentations and warranties.  The escrow fund is eligible for releaseafter twelve months.  The difference between the purchase price and thefair value of the acquired net assets of Dreamtime Baby of $6,620,057 wasrecorded as goodwill.

F-16

          The following tablesummarizes the estimated fair values of the assets acquired and liabilitiesassumed at the date of acquisition, September 13, 2005:  

Current assets

 

$

822,908

 

Property and equipment

 

 

12,511

 

Intangible assets

 

 

190,000

 

Goodwill

 

 

6,620,057

 

 

 

 

Total assets acquired

 

 

7,645,476

 

Current liabilities assumed

 

 

(548,605

)

 

 

 

Net assets acquired

 

$

7,096,871

 

 

 

 

          Of the $190,000 ofacquired intangible assets, $140,000 was assigned to the Dreamtime Baby tradename that is being amortized over five years, and $50,000 was assigned to anon-competition agreement.  The non-competition agreement has a useful lifeof 3 years.  Of the $6,620,057 of goodwill, none is expected to bedeductible for tax purposes.  

          The amortizationexpense relating to the acquired intangible assets has no associated tax impactsince the acquisition of Dreamtime Baby was a stock purchase and any acquiredintangible assets would not be deductible for tax purposes.   

          The accompanyingunaudited pro forma summary represents consolidated results of operations forBabyUniverse as if the acquisition of Dreamtime Baby had been consummated onJanuary 1, 2004.  Certain pro forma adjustments were reflected in theconsolidated results of operations as follows:

 

•

Selling, general and administrative expenses (“SGA”) were adjusted toreflect Dreamtime Baby’s officer’s salary on a“going-forward” basis as agreed to in an employment contract enteredinto by BabyUniverse and the former stockholder of Dreamtime Baby.

 

 

 

 

•

The amortization expense of certain intangible assets that were created inconnection with the acquisition of Dreamtime Baby was reflected as if theacquisition had occurred on January 1, 2004.

 

 

 

 

•

 The weighted average shares outstandingused to compute earnings per share were increased to reflect the 53,165 sharesissued as part of the aggregate purchase price as well as the shares sold in theCompany’s initial public offering. The tax effect has been omitted becauseBabyUniverse believes it can apply its net operating loss carryforwards toprofits generated.

          The unaudited pro formainformation does not necessarily reflect the actual results that would have beenachieved, nor is it necessarily indicative of future consolidated results ofBabyUniverse. 

 

 
**Year Ended December 31,**
 

 

 

 

 

 

**2005**

 

**2004**

 

 

 

 

 

Gross sales

 

$

30,430,496

 

$

20,772,899

 

Net income

 

$

475,875

 

$

898,804

 

Earnings per common share:

 

 

 

 

 

 

 

Basic

 

$

0.10

 

$

0.21

 

Diluted

 

$

0.10

 

$

0.18

 

Weighted average common   shares outstanding:

 

 

 

 

 

 

 

Basic

 

 

4,899,160

 

 

4,338,547

 

Diluted

 

 

5,361,377

 

 

5,052,338

 

F-17

**Note 3 – Inventory**

          Inventory, whichconsists primarily of car seats, strollers, bedding, furniture, baby toys,learning tools and other small items available for sale, is accounted for usingthe first-in first-out (“FIFO”) method and is valued at the lower ofcost or market value. This valuation requires the Company to make judgments,based on currently-available information, about the likely method ofdisposition, such as sales to individual customers, returns to product vendors,or liquidations, and expected recoverable values of each method of disposition.Reserves for obsolescence at December 31, 2006 and 2005 amounted to $49,000 and$0, respectively. 

          We generally own andhold only a portion of the inventory needed to support our level of sales.Although we have continued to increase inventory of those items with lower riskbased on higher demand and turnover, a significant portion of the products weoffer is owned by our suppliers. This enables us to reduce some of the cost andrisk associated with carrying a full inventory of the products we sell. Uponreceipt of a customer order for a specific product that will be drop-shippedfrom a supplier, we simultaneously purchase that product from our supplier, whoships it directly to our customer. Since our inception, our business model hasminimized inventory risk by maximizing the numbers of products we sell that areowned by others. 

**Note 4 — Goodwill**

          Intangible assetswith indefinite lives and goodwill are not amortized, but are tested at leastannually for impairment, or if circumstances change that will more likely thannot reduce the fair value of the reporting unit below its carryingamount.

          On January13, 2006, BabyUniverse acquired Posh Tots (See Note 2 –Acquisitions).  The following table sets forth goodwill, net, as ofDecember 31, 2005 and 2006:

 

 

**December   31,   2005**

 

**Acquisition/   Adjustments**

 

**Impairment   Losses**

 

**December 31,   2006**

 

 

 

 

 

 

 

DreamtimeBaby

 

$

6,620,057

 

$

140,067

 

$

—  

 

$

6,760,124

 

Posh Tots

 

 

—  

 

 

12,071,917

 

 

—  

 

 

12,071,917

 

 

 

 

 

 

 

 

 

$

6,620,057

 

$

12,211,984

 

$

—  

 

$

18,832,041

 

 

 

 

 

 

 

          During 2006, theCompany recognized additional adjustments to the DreamtimeBaby goodwill of$140,067. These adjustments resulted from additional transaction costs for theDreamtimeBaby acquisition of approximately $43,000, as well as a settlement withthe seller that reduced the post-closing working capital adjustment by $97,000.The Company also recognized an additional adjustment during 2006 to the PoshTots goodwill resulting from a settlement with the seller that reduced thepost-closing working capital adjustment by $142,705.

**Note 5 — Intangible Assets**

          BabyUniverse reviewsfor the impairment of identifiable intangible assets whenever events or changesin circumstances indicate that the carrying amount of an asset may not berecoverable in accordance with the provisions of SFAS No. 142, *Goodwill andOther Intangible Assets,*and SFAS No. 144, *Accounting for the Impairmentor Disposal of Long-Lived Assets*. 

          Identifiableintangible assets are amortized under the straight-line method over the periodof expected benefit ranging from three to five years, unless they weredetermined to be subject to indefinite lives.  The following table setsforth the components of intangible assets as of December 31, 2006:

F-18

 

 

**Useful   Life**

 

**Gross   Carrying   Amount**

 

**Acquisition**

 

**Accumulated   Amortization**

 

**Net**

 

 

 

 

 

 

 

 

**Dreamtime   Baby**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Trade name

 

 

5 years

 

$

140,000

 

$

—  

 

$

(36,167

)

$

103,833

 

Non-competition Agreement

 

 

3 years

 

 

50,000

 

 

—  

 

 

(21,527

)

 

28,473

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

190,000

 

 

—  

 

$

(57,694

)

 

132,306

 

 

 

 

 

 

 

 

 

 

**Posh Tots**

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Trade name

 

 

Indefinite

 

 

—  

 

 

2,200,000

 

 

—  

 

 

2,200,000

 

Customer list

 

 

4 years

 

 

—  

 

 

260,000

 

 

(66,667

)

 

193,333

 

Contents of catalogue / website

 

 

3 years

 

 

—  

 

 

200,000

 

 

(65,000

)

 

135,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

—  

 

 

2,660,000

 

 

(131,667

)

 

2,528,333

 

 

 

 

 

 

 

 

 

 

**ePregnancy**

 

 

3 years

 

 

—  

 

 

184,257

 

 

(33,269

)

 

150,988

 

 

 

 

 

 

 

 

 

 

**Total   Intangible Assets**

 

 

 

 

$

190,000

 

$

2,844,257

 

$

(222,630

)

$

2,811,627

 

 

 

 

 

 

 

 

 

 

          Amortizationexpense for the twelve month period ended December 31, 2006 was $209,602. Estimated amortization expense for the twelve months ending December 31 is asfollows:

2007

 

 

237,752

 

2008

 

 

232,891

 

2009

 

 

121,150

 

2010

 

 

19,834

 

 

 

 

Total

 

$

611,627

 

 

 

 

**Note 6 — Fixed Assets**

          Fixedassets are stated at cost less accumulated depreciation and amortization.Expenditures for ordinary maintenance and repairs are charged to operations asincurred. Major additions and improvements are capitalized using thestraight-line method over the estimated useful life of the asset. The Companyhas elected to capitalize outside development costs related to the developmentof its software following the guidelines of the AICPA’s Statement ofPosition (SOP) 98-1 which states that application and development costassociated with the purchase or development of software that is for the internaluse of a company, shall be capitalized and depreciated over the estimated usefullife of the software.

 

 

**2006**

 

**2005**

 

**Estimated   Useful Life**

 

 

 

 

 

 

Software

 

$

1,674,993

 

$

683,730

 

 

5 yrs

 

Computers and peripherals

 

 

607,944

 

 

188,179

 

 

3 - 5 yrs

 

Telephone equipment

 

 

83,668

 

 

33,524

 

 

3 yrs

 

Furniture

 

 

337,812

 

 

30,652

 

 

5 - 7 yrs

 

Equipment

 

 

188,348

 

 

33,444

 

 

5 - 7 yrs

 

Leasehold improvements

 

 

68,183

 

 

9,712

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

2,960,948

 

 

979,241

 

 

 

 

Less:  Accumulated depreciation   and amortization

 

 

1,024,208

 

 

312,448

 

 

 

 

 

 

 

 

 

 

 

Net fixed assets

 

$

1,936,740

 

$

666,793

 

 

 

 

 

 

 

 

 

 

 

All of the Company’s fixed assets have been pledged as security for theHercules Technology note payable, see Note 8.

F-19

**Note 7 — Accounts Payable and Accrued Expenses**

          Accounts payable andaccrued expenses consist of the following:

 

 

**December 31,**

 

 

 

 

 

 

**2006**

 

**2005**

 

 

 

 

 

Accounts payable

 

$

4,539,560

 

$

2,621,424

 

Accrued inventory purchases

 

 

9,398

 

 

153,023

 

Accrued accounting fees

 

 

120,000

 

 

85,000

 

Accrued payroll and benefits

 

 

119,447

 

 

53,305

 

Accrued credit card fees

 

 

44,773

 

 

47,082

 

Accrued customer refunds

 

 

68,370

 

 

34,964

 

Accrued taxes

 

 

6,391

 

 

26,739

 

Other accrued expenses

 

 

257,872

 

 

119,500

 

 

 

 

 

Total accounts payable and accrued expenses

 

$

5,165,811

 

$

3,141,037

 

 

 

 

 

**Note 8 – Notes and Capital Lease Payables**

          Notes andcapital leases outstanding at December 31, 2006 and 2005 were asfollows:

 

 

**December 31,   2006**

 

**December 31,   2005**

 

 

 

 

 

Note payable, prime rate plus 2.35%    (10.6%), due July 2009

 

$

5,000,000

 

$

—  

 

Note payable, at prime (8.25%), due July 2008

 

 

2,000,000

 

 

—  

 

Unamortized debt discount and finance costs associated with note   payable

 

 

(689,029

)

 

—  

 

Capital leases

 

 

27,960

 

 

8,061

 

 

 

 

 

Total debt

 

 

6,338,931

 

 

8,061

 

Less short-term debt and current maturities

 

 

(561,090

)

 

(3,300

)

 

 

 

 

Total Note and Capital Lease   Payables - long-term

 

$

5,777,841

 

$

4,761

 

 

 

 

 

***Hercules Note***

          On July 11,2006, the Company completed a $5.0 million debt financing transaction withHercules Technology Growth Capital, Inc. Proceeds from the financing were usedprimarily to refinance the Company’s existing debt, thereby enabling theCompany to realize a negotiated $1.5 million discount on the $6.0 millionnote.  The pre-payment and principal reduction in the note payable of $1.5million was recognized in other income and expense as a gain on earlyextinguishment of debt in accordance with the accounting treatment prescribed byAccounting Principles Board Opinion 26, *Early Extinguishment of Debt*, andSFAS No. 145, *Rescission of FASB Statements No. 4, 44, and 64, Amendmentof FASB Statement No. 13, and Technical Corrections*.  The Companypreviously stated in its Form 10-Q for the quarter ended June 30, 2006 (Note 9– Subsequent Event) that,**“**The pre-payment and principalreduction in the note payable subsequent to June 30, 2006 will reduce theCompany’s goodwill amount related to the Posh Tots acquisition by $1.5million.” This initial determination as to the proposed accountingtreatment was based on limited consideration at that time of the relevantaccounting pronouncements applicable to the underlying facts of thistransaction. Based on subsequent review and consideration, the Company believesthat SFAS 141, “Business Combinations”,  is not relevant to theessential facts of this transaction.

          The SeniorLoan and Agreement (“Loan” or “Loan Agreement”) is for aterm of 36 months, at an interest rate equal to the prime interest rate plus2.35%. The Loan Agreement allows for interest-only payments for 12 months, withprincipal and interest payments due monthly thereafter. The interest-only periodand the term of the Loan may be extended up to six months based on meetingcertain financial tests. The Loan is secured by a perfected first prioritysecurity interest in all of the Company’s tangible and intangible assetsand requires compliance with certain financial covenants, including a currentratio requirement, by which the Company must maintain a current ratio of atleast .85 for the quarter ending September 30, 2006, at least .90 for thequarter ending December 31, 2006, and at least 1.0 for each subsequent calendarquarter thereafter. The Company was in compliance with all covenants as ofDecember 31, 2006. (See PART II, OTHER INFORMATION - Item 1A., Risk Factors, forfurther information.)

F-20

          In conjunction withthe Loan Agreement, the Company issued a warrant to Hercules Technology GrowthCapital, Inc. to purchase 91,912 shares of common stock of the Company at anexercise price of $8.16 per share. The warrant vested immediately upon executionof the Loan Agreement and is exercisable for seven years. The Company hasevaluated the warrants under the provisions of EITF 00-19 and has determinedthat it qualifies for equity treatment. Therefore, the pro-rata fair value ofthe warrant as of July 11, 2006 of $333,034 was classified as debt discount andis being amortized over the 36-month term of the Loan in accordance withAccounting Principles Board Opinion No. 14.

***Lydian Note***

          On December 29,2006, BabyUniverse, Inc. entered into a Loan Agreement (the “Lydian LoanAgreement”) with Lydian Private Bank, pursuant to which Lydian Private Bankprovided a term loan of $2,000,000 to the Company (the “Lydian Loan”),evidenced by a Promissory Note in that principal amount dated December 29, 2006(the “Lydian Note”). The Lydian Loan bears interest at a floating rateof interest equal to the base rate on corporate loans posted by at least 75% ofthe nation’s largest banks, known as the “Wall Street JournalPrime,” which interest is payable monthly beginning on February 1, 2007.The maturity date of the Lydian Loan is July 1, 2008, at which time alloutstanding principal and accrued but unpaid interest thereunder must be repaidto Lydian Private Bank. 

          As security for theLydian Loan, Wyndcrest BabyUniverse Holdings II, LLC, a Florida limitedliability company, and Wyndcrest BabyUniverse Holdings III, LLC, a Floridalimited liability company, each of which is controlled by John C. Textor, theCompany’s Chairman and Chief Executive Officer, pledged to Lydian PrivateBank shares of the Company’s Common Stock held by them, which shares alsoserve as collateral under a loan previously extended to such pledgors by LydianPrivate Bank. In addition, each such pledgor and Mr. Textor have executed aguaranty of the Lydian Loan in favor of Lydian Private Bank. The Lydian LoanAgreement and the Lydian Note contain customary events of default for facilitiesof this type; upon the occurrence of any such event of default, Lydian PrivateBank shall be entitled to all rights and remedies available to it against theCompany under law and the Lydian Loan Agreement and the Lydian Note, including,without limitation, the right to accelerate and demand immediate repayment ofall sums due thereunder.

**Note 9 — Stockholders’ Equity (Deficit)**

          In October 2004 theBoard of Directors authorized the grant of options to purchase 156,372 shares of common stock to three members ofthe Board of Advisors. One-third of the options vests 4 months from thegrant date and the balance vests in equal shares on the following twoanniversaries of the grant date. On April 27, 2005 the vesting of all optionswere accelerated. The options must be exercised within ten years from the grantdate. The exercise price of each option is $1.27 per share. 

          On January 18, 2005,the Board of Directors authorized the grant of options to purchase 52,124 shares of common stock to a member of theBoard of Directors. One-third of the options vested 4 months from the grantdate and the balance vests in equal shares on the following two anniversaries ofthe grant date. On April 27, 2005 the vesting of all options were accelerated.The options must be exercised within ten years from the grant date. The exerciseprice of each option is $6.25 per share. 

          On April 27, 2005,the holders of approximately 72% of the Company’s then-issued andoutstanding common stock, by majority written consent in lieu of a meeting ofshareholders, authorized a 525:1 stock split and accompanying amendment to theCompany’s amended and restated articles of incorporation.  On July 12,2005, the holders of approximately 78% of the Company’s then-issued andoutstanding common stock, by majority written consent in lieu of a meeting ofshareholders, authorized a 19:18 stock split and accompanying amendment to theCompany’s amended and restated articles of incorporation. All references tonumbers of shares in the accompanying financial statements and notes have beenadjusted to give retroactive effect to these stock splits.

          During 2005, theBoard of Directors authorized the grant to three employees and two directors of177,221 shares of restricted, nonvested stock, with vesting periods rangingbetween two and four years, in consideration of future services to be renderedto the Company.  Unearned compensation of $619,528 was recorded based onthe fair values at the dates of grant, and compensation expense is recognizedduring the vesting periods.  Stock-based compensation of $65,842 related tothe restricted stock grants was recorded during 2005.

F-21

          On August 2, 2005,the Company’s Registration Statement on Form S-1 was declaredeffective for its initial public offering, pursuant to which the Company soldtwo million shares of common stock at $9.50 per share. The Company’scommon stock commenced trading on August 3, 2005. The offering closed on August8, 2005, and the Company received net proceeds of approximately$16.3 million (after payments to underwriters of $1.9 million,issuance of 130,000 warrants and additional estimated offering expenses of$757,000).  

          The warrantto purchase 130,000 shares of the Company’s common stock is initiallyexercisable by the underwriters on or after February 5, 2006 and until the closeof business on August 2, 2010 at a purchase price of $11.875 per share. The holders may require the Company to convert the value of this warrant intoshares of common stock through a cashless exercise option, in lieu of thepayment by the holders of the exercise price.  The value of the cashlessexercise option would be determined by the excess of the current market price onthe exercise date over the exercise price of the shares of common stock. Thevalue so determined would be converted to equivalent shares of common stock bydividing it by the current market price of the common stock on the exercisedate.  The warrant also contains certain anti-dilution privileges for stocksplits, acquisitions, and other restructurings; allows the holder at any timeafter the exercise date to request the company to file a registration statementfor the underlying shares and perform certain other registration relatedactivities as required; provides for certain payments to the holder in the eventof delays with respect to the filing of a requested registration statement; andentitles the holder to unlimited “piggyback” registration rights. TheCompany has evaluated the warrants under the provisions of EITF 00-19 and hasdetermined that it qualifies for equity treatment.

          On October 1, 2005,the Company granted 7,500 restricted, non-vested shares to an investor relationsfirm pursuant to a services agreement dated October 1, 2005.  The shareswere issued subject to a termination clause in favor of the Company stating thatthey were unvested and refundable to the Company until January 1, 2006, at whichtime, the services agreement had not been terminated by the Company, and theshares became fully vested.

          On January 13, 2006,we granted options to purchase 50,000 shares of common stock to officers of PoshTots LLC in connection with the Company’s purchase of the assets of PoshTots LLC.   These options bore an exercise price of $8.10, the closingprice on the date of the grant, vested over a two year period and were toexpireafter 25 months.  Subsequent to January 13, 2006, 30,000 options werecancelled in connection with one officer terminating employment with theCompany.

          On January 13, 2006,we granted options to purchase 75,000 shares of common stock to employees ofPosh Tots LLC in connection with the Company’s purchase of the assets ofPosh Tots LLC.   These options bore an exercise price of $8.10, theclosing price on the date of the grant, vested over a three year period andexpire after 37 months.  Subsequent to January 13, 2006, 15,000 optionswere cancelled in connection three employees terminating employment with theCompany.

          On April 3, 2006,the Company granted options to purchase 50,000 shares of common stock to a keyemployee related to the development and implementation of the BabyTV new mediaconcept.  These options bear an exercise price of $9.86, the closing priceon the date of the grant, vest quarterly over a four year period and expireafter 48 months.  

          On November 16,2006, the Company granted options to purchase 2,000 shares of common stock, toan employee.  These options bear an exercise price of $6.84, the closingprice on the date of the grant, 500 options vested immediately, and theremaining shares vest over two years.  These options expire in 25months.

          On December 11,2006, the Company granted 25,000 restricted shares of the Company’s commonstock to an employee.  These shares vest over a four yearperiod.

**Note 10 – Operational Reorganization and Restructuring**

          During the firstquarter of 2006, the Company initiated a multi-faceted reorganization andrestructuring plan (the “Plan”), which was essentially completedduring the second quarter of 2006. The objectives of the Plan were to (1)integrate the business operations of two recent acquisitions with theBabyUniverse e-commerce business in order to achieve greater efficiency, and (2)benefit from certain business strengths and best practices of the acquiredorganizations. The Plan was comprised of the following specificelements:

F-22

 

•

Open the Company’s new distribution center in 23,000 square feet of leasedspace in Las Vegas in January 2006.

 

 

 

 

•

Implement a new warehouse management system for the Las Vegas distributioncenter by late March 2006.

 

 

 

 

•

Relocate DreamtimeBaby’s business operations and inventory from its LosAngeles-area headquarters to the Las Vegas distribution center by late March2006.

 

 

 

 

•

Relocate the BabyUniverse inventory and distribution activities from its FortLauderdale warehouse to the Las Vegas distribution center during February2006.

 

 

 

 

•

Restructure the BabyUniverse e-commerce business operations by consolidatingcertain activities within the Posh Tots’ management organization inRichmond during May 2006.

 

 

 

 

•

Reorganize and consolidate the senior management organization in corporateoffices in Jupiter, Florida during June 2006. The corporate offices house theCompany’s executive management organization and certain corporate servicesincluding strategic planning, finance, technology, logistics and new mediadevelopment.

          The restructuringexpenses related to the Plan were accounted for pursuant to Statement ofFinancial Accounting Standard No. 146, *Accounting for Costs Associated withExit or Disposal Activities*, which addresses exit or disposal activitiesincluding one-time involuntary employee termination benefits, contracttermination costs and costs to consolidate facilities or relocateemployees.  The total expense incurred for restructuring activities wasapproximately $506,000, of which $116,000 and $390,000 were recognized duringthe first and second quarters of 2006, respectively.

          The major costsassociated with implementing the plan were as follows:

 

•

One-time termination benefits were provided to certain current employees thatwere involuntarily terminated pursuant to the Plan, which was announced inFebruary.  The affected employees were required to render service throughvarious dates to June 30, 2006 in order to receive the termination benefits. Thetotal expense incurred for one-time termination benefits was approximately$111,000. Approximately $43,000 and $68,000 of one-time termination benefitswere recognized as restructuring expenses for the first and second quarters of2006, respectively.

 

 

 

 

•

We ceased using leased space for our offices and warehouse in Fort Lauderdale,Florida during the second quarter of 2006. We recognized a liability of $72,752during the quarter ended June 30, 2006, which represents the fair value of thelease costs that will continue to be incurred under the lease, net of sub-leaseopportunities, for its remaining term through May 2008.

 

 

 

 

•

Other costs incurred as a result of the restructuring include costs toconsolidate or close our facilities in Fort Lauderdale and Los Angeles and torelocate certain activities to the Las Vegas distribution center, to PoshTots’ headquarters in Richmond, and to our corporate office in Jupiter,Florida. The total amount of other restructuring costs was approximately$323,000, of which $74,000 and $249,000 were incurred and recognized asrestructuring expenses in the first and second quarters of 2006,respectively.

**Note 11 — Stock Option Plan**

          The Company’s2001 Stock Award Plan was amended and restated in April 2005 by our board ofdirectors and shareholders and renamed the “BabyUniverse 2005 StockIncentive Plan” (Plan) under which officers, key employees, andnon-employee directors may be granted options to purchase shares of theCompany’s authorized but un-issued common stock. Under the Plan, theexercise price of each option equals the market price of the stock on the dateof grant, the graded vesting period generally ranges between two and five years,and the contractual term ranges between two and ten years. See *Accounting forStock Based Compensation in Note 1 — Description of the Companyand Summary of Significant Accounting Policies*.

          The fair value ofeach stock option granted is estimated on the date of the grant using theBlack-Scholes option pricing model.  The Company uses an estimatedforfeiture rate of 0% due to limited experience with historical employeeforfeitures.  The Black-Scholes option pricing model also requiresassumptions for risk free interest rates, dividend rate, stock volatility andexpected life of an option grant.  The risk free interest rates used rangedbetween 4.2% and 4.84% and were based on the U.S. Treasury Bill rate formaturities consistent with the expected life of the options which ranged between1 to 3 years.  Dividend rates are based on the Company’s dividendhistory.  The stock volatility factor used of 56% was based on a peer groupanalysis of the stock market prices for eight comparable companies determined bythe Company.  Expected life is determined using the “simplifiedmethod” permitted by the SEC’s Staff Accounting Bulletin 107,since the Company does not have sufficient historical experience.  The fairvalue of each option grant is recognized as compensation expense over thevesting period of the option on a straight line basis.

F-23

          The following tablesummarizes information about stock option transactions for the years endedDecember 31, 2006, 2005 and 2004:

 

 

**2006**

 

**2005**

 

**2004**

 

 

 

 

 

 

 

 

**Shares**

 

**Weighted-   Average   Exercise   Price**

 

**Shares**

 

**Weighted   Average   Exercise   Price**

 

**Shares**

 

**Weighted   Average   Exercise   Price**

 

 

 

 

 

 

 

 

 

Outstanding at beginning of year

 

 

104,248

 

$

3.76

 

 

777,046

 

$

0 .35

 

 

675,356

 

$

0.10

 

Granted

 

 

177,000

 

$

8.58

 

 

52,124

 

 

6.25

 

 

156,372

 

 

1.27

 

Exercised

 

 

-0-

 

 

-0-

 

 

(724,922

)

 

0.28

 

 

(54,682

)

 

0.04

 

Forfeited

 

 

(45,000

)

$

8.10

 

 

-0-

 

 

-0-

 

 

-0-

 

 

-0-

 

 

 

 

 

 

 

 

 

Outstanding at end of year

 

 

236,248

 

$

6.55

 

 

104,248

 

$

3.76

 

 

777,046

 

$

0.35

 

 

 

 

 

 

 

 

 

Options exercisable at year end

 

 

113,082

 

$

4.22

 

 

104,248

 

$

3.76

 

 

633,368

 

$

0.15

 

Weighted-average fair value of options granted during the year

 

 

 

 

$

3.03

 

 

 

 

$

1.73

 

 

 

 

$

0.26

 

          As of December 31,2006, the aggregate intrinsic value of outstanding options was $729,062.

          The following tablesummarizes information about stock options outstanding at December 31,2006:

 

 

**Options   Outstanding**

 

**Options   Exercisable**

 

 

 

 

 

**Range of Exercise Prices**

 

**Number   Outstanding   at 12/31/06**

 

**Weighted-Average   Remaining   Contractual Life   (years)**

 

**Weighted   Average   Exercise Price**

 

**Number   Exercisable at   12/31/06**

 

**Weighted Average   Exercise Price**

 

 

 

 

 

 

 

$0.01 to $3.50

 

 

52,124

 

 

7.76

 

$

1.27

 

 

52,124

 

$

1.27

 

$3.51 to $7.00

 

 

54,124

 

 

7.82

 

$

6.34

 

 

52,624

 

$

6.27

 

$7.01 to $9.86

 

 

130,000

 

 

2.02

 

$

8.78

 

 

8,333

 

$

9.86

 

          The Company recorded $130,007 of compensationexpense for employee stock options during the year ended December 31,2006.   At December 31, 2006 there was a total of $295,955 ofunrecognized compensation costs related to non-vested stock options issued underthe plan and $234,643 of unrecognized compensation expense related to unvestedrestricted stock issued under the 2005 Plan.

          During2006, the Company granted an additional 25,000 of restricted shares under the2005 Stock Incentive Plan, and 60,167 restricted shares vested.  As such,at December 31, 2006 there are 102,054 unvested resticted shares.

          As ofDecember 31, 2006, an aggregate of 405,289 shares of common stock arereserved for issuance under the 2005 Stock Incentive Plan. Restricted stockgrants and stock option grants were outstanding for an aggregate of234,054 shares of stock, and 171,235 shares remained available forgrant. In addition, there were outstanding options to purchase a total of104,248 shares of our common stock, and 20,000 shares of restricted stock,which were granted outside of the 2005 Stock Incentive Plan.  Shares issuedpursuant to the Stock Incentive Plan will be newly-issued and authorized sharesof common stock, or treasury shares.

F-24

**Note 12 — Income Taxes**

Deferred income taxes reflect the nettax effects of temporary differences between the carrying amount of assets andliabilities for financial reporting purposes and amounts used for income taxpurposes. Significant components of the Company’s deferred tax assets andliabilities consist of the following:

 

 

**As of December 31,**

 

 

 

 

 

 

**2006**

 

**2005**

 

 

 

 

 

 

 

**Current**

 

**Non-Current**

 

**Current**

 

**Non-Current**

 

 

 

 

 

 

 

Deferred tax assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

Net operating loss carryforwards

 

$

2,743,018

 

$

—  

 

$

1,212,200

 

$

—  

 

State income tax

 

 

—  

 

 

25,143

 

 

13,888

 

 

6,651

 

Accrued expenses

 

 

154,759

 

 

—  

 

 

24,499

 

 

—  

 

Other

 

 

67,154

 

 

—  

 

 

26,008

 

 

—  

 

 

 

 

 

 

 

Total net deferred tax assets

 

 

2,964,931

 

 

25,143

 

 

1,276,595

 

 

6,651

 

Deferred tax liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

Depreciation and amortization

 

 

—  

 

 

493,001

 

 

19,135

 

 

113,490

 

State income tax

 

 

149,251

 

 

—  

 

 

66,082

 

 

—  

 

 

 

 

 

 

 

Total deferred tax liabilities

 

 

149,251

 

 

493,001

 

 

85,217

 

 

113,490

 

 

 

 

 

 

 

Net deferred tax assets

 

 

2,815,680

 

 

(467,858

)

 

1,191,378

 

 

(106,839

)

Valuation allowance

 

 

2,815,680

 

 

(467,858

)

 

1,193,445

 

 

(95,283

)

 

 

 

 

 

 

Total net deferred tax assets

 

$

—  

 

$

—  

 

$

(2,067

)

$

(11,556

)

 

 

 

 

 

 

F-25

          Net deferred tax assets have been fully offset by avaluation allowance due to the uncertainty of realizing such benefit. AtDecember 31, 2006, the Company had net operating loss carryforwards ofapproximately $6.9 million for federal and $6.8 million for state tax purposeswhich are set to expire in various years through 2026.

          Thereconciliation of income tax expense computed at the U.S. federal statutory rateto income tax expense for the years ended December 31, 2006, 2005 and 2004are as follows:

 

 

**Year Ended December 31,**

 

 

 

 

 

 

**2006**

 

**2005**

 

**2004**

 

 

 

 

 

 

Income taxes (benefit) at federal statutory rate (34%)

 

$

(1,136,858

)

 

34.0

%

$

(157,861

)

 

34.0

%

$

75,161

 

 

34.0

%

State income taxes, net of federal benefit

 

 

(148,172

)

 

4.4

%

 

(20,536

)

 

4.4

%

 

8,258

 

 

3.5

%

Expenses not deductible for U.S. tax purposes

 

 

49,320

 

 

-1.5

%

 

(122,487

)

 

26.4

%

 

2,183

 

 

-0.8

%

Change in valuation allowances and other

 

 

1,235,709

 

 

-36.9

%

 

328,884

 

 

-70.8

%

 

(85,602

)

 

-36.8

%

 

 

 

 

 

 

 

 

Provision for income taxes

 

$

—  

 

 

0.0

%

$

28,000

 

 

-6.0

%

$

—  

 

 

0.0

%

 

 

 

 

 

 

 

 

**Note 13 — Commitments and Contingencies**

***Commitments***

 

The Company leases office and warehousespace as follows:

 

 

 

 

•

We lease approximately9,700 square feet of office space in Jupiter, Florida for our corporateheadquarters.  The lease commenced on April 1, 2006 for a 5-year and9-month term.

 

 

 

 

•

We lease 9,800 square feet ofoffice and warehouse space in Ft. Lauderdale, Florida that previouslyserved as our corporate headquarters and distribution center under a lease thatexpires in May 2008.  In June, 2006 the Company entered into a subleaseagreement for this space under which the Company is to receive average monthlyrents of approximately $9,300 through May 2008

 

 

 

 

•

We lease approximately23,000 square feet of warehouse space for our distribution center in LasVegas, Nevada under the terms of a 5-year lease beginning December 15, 2005 andterminating December 14, 2010.

 

 

 

 

•

We leased approximately4,000 square feet of office and warehouse space for our Dreamtime Babybusiness in Culver City, California under a lease that expired on March 31,2006.

 

 

 

 

•

We leased approximately7,625 square feet of office and warehouse space for the Posh Totsheadquarters in Glen Allen, Virginia under a lease that expired on August 31,2006. On February 28, 2006 we signed a lease for approximately 12,000 squarefeet of office and warehouse space to replace the existing headquartersspace.

          Rentexpense charged to operations under these operating leases was $667,972,$150,796 and $79,023 for the years ended December 31, 2006, 2005 and 2004,respectively.

F-26

          Future lease obligations for the years endingDecember 31 are as follows:

 

 

**Operating Leases**

 

**Capital Leases**

 

 

 

 

 

**2007**

 

**$**

**565,290**

 

**$**

**7,558**

 

**2008**

 

 

**600,467**

 

 

**5,090**

 

**2009**

 

 

**594,877**

 

 

**4,360**

 

**2010**

 

 

**607,591**

 

 

**4,263**

 

**2011**

 

 

**464,715**

 

 

**4,263**

 

**Thereafter**

 

 

**310,182**

 

 

**2,426**

 

 

 

 

 

**Total**

 

**$**

**3,234,122**

 

**$**

**27,960**

 

 

 

 

 

          Capital leases consist of office and warehouseequipment with capitalized amounts of $39,727 and $15,697 for the years endedDecember 31, 2006 and 2005, respectively.

***Litigation***

          The Companyis engaged in legal actions that arise from time to time in the normal course ofbusiness.  The Company believes that the ultimate outcome of these actionswill not have a material impact on its financial position, results of operationsor cash flows.

***Sales Tax***

          Currently,decisions of the U.S. Supreme Court restrict the imposition of obligationsto collect state and local sales and use taxes with respect to sales made overthe Internet. However, implementation of the restrictions imposed by theseSupreme Court decisions is subject to interpretation by state and local taxingauthorities. While we believe that these Supreme Court decisions currentlyrestrict state and local taxing authorities outside the states of Florida,Nevada and  Virginia from requiring us to collect sales and use taxes frompurchasers located within their jurisdictions, taxing authorities outside thestates of Florida, Nevada and  Virginia could disagree with ourinterpretation of these decisions. Moreover, a number of states, as well as theU.S. Congress, have been considering various initiatives that could limitor supersede the Supreme Court’s position regarding salesand use taxes on Internet sales. If any state or local taxing jurisdiction wereto disagree with our interpretation of the Supreme Court’s current positionregarding state and local taxation of Internet sales, or if any of theseinitiatives were to address the Supreme Court’s constitutional concerns andresult in a reversal of its current position, we could be required to collectsales and use taxes from purchasers located in states other than Florida, Nevadaand Virginia. An unfavorable resolution of some or all of these matters couldmaterially affect our business, results of operations, financial position, orcash flows in a particular period.

**Note 14 — Earnings (Loss) Per Share**

          Basicearnings (loss) per share is based on the weighted average number of commonshares outstanding.  Diluted earnings (loss) per share is based on theweighted average number of common shares and equivalents outstanding. Commonshare equivalents included in the computation represent shares issuable uponassumed exercise of outstanding stock options and warrants, and the non-vestedportion of restricted stock.

F-27

          The following table sets forth the computationof basic and diluted earnings (loss) per share:

 

 

**Year Ended December 31,**

 

 

 

 

 

 

**2006**

 

**2005**

 

**2004**

 

 

 

 

 

 

Net income (loss)

 

$

(3,343,700

)

$

(492,297

)

$

221,061

 

*Weighted   average common shares outstanding*

 

 

*5,419,872*

 

 

*3,667,913*

 

 

*2,285,382*

 

Basic earnings (loss) per common share

 

$

(0.62

)

$

(0.13

)

$

0.10

 

*Dilutive   effect of stock options and warrants*

 

 

*—  *

 

 

*—  *

 

 

*713,787*

 

*Common   stock and common stock equivalents*

 

 

*5,419,872*

 

 

*3,667,913*

 

 

*2,999,169*

 

Diluted earnings (loss) per share

 

$

(0.62

)

$

(0.13

)

$

0.07

 

          The following is a summary of the securitiesoutstanding during the respective periods that have been excluded from thecalculations because the effect on earnings (loss) per share would have beenantidilutive:

 

 

**Year Ended December 31,**

 

 

 

 

 

 

**2006**

 

**2005**

 

**2004**

 

 

 

 

 

 

*Dilutive effect of stock options and warrants*

 

 

*686,497*

 

 

*474,162*

 

 

*713,787*

 

**Note 15 — SegmentInformation**

          The Companyoperates in a single business segment as a leading online retailer and contentprovider of baby, toddler and maternity products and information through severalonline websites.

**Note 16 — Quarterly Results**

          The following tablescontain selected unaudited statement of operations information for each quarterof 2006, 2005, and 2004. The following information reflects all normal recurringadjustments necessary for a fair presentation of the information for the periodspresented. The operating results for any quarter are not necessarily indicativeof results for any future period. Unaudited quarterly results were asfollows:

 

 

**Year Ended December 31, 2006**

 

 

 

 

 

 

**Fourth   Quarter**

 

**Third   Quarter**

 

**Second   Quarter**

 

**First   Quarter**

 

 

 

 

 

 

 

Net sales

 

$

8,681.2

 

$

8,875.3

 

$

8,524.9

 

$

9,467.8

 

Gross profit

 

 

2,176.6

 

 

2,673.6

 

 

2,355.2

 

 

2,954.5

 

Income (loss) before income taxes

 

 

(2,044.7

)

 

72.9

 

 

(1,218.3

)

 

(175.7

)

Provision (benefit) for income taxes

 

 

0.0

 

 

(30

)

 

(13.0

)

 

21.0

 

Net income (loss)

 

 

(2,044.7

)

 

102.9

 

 

(1,205.3

)

 

(196.7

)

Earnings (loss) per common share:

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

(0.36

)

 

0.02

 

 

(0.23

)

 

(0.04

)

Diluted

 

 

(0.36

)

 

0.02

 

 

(0.23

)

 

(0.04

)

F-28

 

 

**Year Ended December 31, 2005**

 

 

 

 

 

 

**Fourth   Quarter**

 

**Third   Quarter**

 

**Second   Quarter**

 

**First   Quarter**

 

 

 

 

 

 

 

Net sales

 

$

8,169.6

 

$

5,717.2

 

$

5,284.1

 

$

4,535.6

 

Gross profit

 

 

2,457.0

 

 

1,498.7

 

 

1,285.4

 

 

1,048.1

 

Income (loss) before income taxes

 

 

80.3

 

 

(125.3

)

 

(322.1

)

 

(97.1

)

Provision for income taxes

 

 

(28.0

)

 

—  

 

 

—  

 

 

—  

 

Net income (loss)

 

 

52.3

 

 

(125.3

)

 

(322.1

)

 

(97.1

)

Earnings (loss) per common share:

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.01

 

$

(0.03

)

$

(0.11

)

$

(0.04

)

Diluted

 

$

0.01

 

$

(0.03

)

$

(0.11

)

$

(0.04

)

 

 

**Year Ended December 31, 2004**

 

 

 

 

 

 

**Fourth   Quarter**

 

**Third   Quarter**

 

**Second   Quarter**

 

**First   Quarter**

 

 

 

 

 

 

 

Net sales

 

$

4,531.6

 

$

3,864.9

 

$

2,767.8

 

$

3,112.3

 

Gross profit

 

 

1,218.5

 

 

937.0

 

 

658.7

 

 

872.1

 

Income (loss) before income taxes

 

 

129.0

 

 

45.1

 

 

(72.4

)

 

119.4

 

Provision for income taxes

 

 

—  

 

 

—  

 

 

—  

 

 

—  

 

Net income (loss)

 

 

129.0

 

 

45.1

 

 

(72.4

)

 

119.4

 

Earnings (loss) per common share:

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.06

 

$

0.02

 

$

(0.03

)

$

0.05

 

Diluted

 

$

0.04

 

$

0.02

 

$

(0.03

)

$

0.04

 

The sum of quarterly basic and diluted per share amounts may not equal per share amounts reported for year ended periods.  This is due to changes in the number of weighted average shares outstanding and the effects of rounding for each period.

**Note 17 — Transactions With Related Parties**

***Private Placement of Equity Securities***

          On September 22, 2006, BabyUniverse, Inc. closed on $2 million in new equity financing.  The equity financing was provided by affiliates of Wyndcrest Holdings, LLC, a company controlled by BabyUniverse CEO John Textor.  In connection with the financing, the Company received aggregate proceeds of approximately $2 million, based on the issuance of 263,852 shares of common stock priced at $7.58 per share, a 7.5% premium to the closing price on September 22, 2006.  These funds will be used for general corporate purposes.

          The shares of the common stock issued in the private placement were not registered under the Securities Act of 1933, pursuant to the exemption provided in Section 4(2), and may not be subsequently offered or sold by the investors in the United States absent registration or an applicable exemption from the registration requirements. BabyUniverse filed a Registration Statement on Form S-3 (No. 333-139712) on December 28, 2006 covering registration of the common stock acquired by the investors pursuant to the privateplaement.

          On December 29, 2006, BabyUniverse, Inc. entered into a Loan Agreement (the “Lydian Loan Agreement”) with Lydian Private Bank, pursuant to which Lydian Private Bank provided a term loan of $2,000,000 to the Company (the “Lydian Loan”), evidenced by a Promissory Note in that principal amount dated December 29, 2006 (the “Lydian Note”). The Lydian Loan bears interest at a floating rate of interest equal to the base rate on corporate loans posted by at least 75% of the nation’s largest banks, known as the “Wall Street Journal Prime,” which interest is payable monthly beginning on February 1, 2007. The maturity date of the Lydian Loan is July 1, 2008, at which time all outstanding principal and accrued but unpaid interest thereunder must be repaid to Lydian Private Bank. 

F-29

          As security for theLydian Loan, Wyndcrest Baby Universe Holdings II, LLC, a Florida limitedliability company, and Wyndcrest BabyUniverse Holdings III, LLC, a Floridalimited liability company, each of which is controlled by John C. Textor, theCompany’s Chairman and Chief Executive Officer, pledged to Lydian PrivateBank shares of the Company’s Common Stock held by them, which shares alsoserve as collateral under a loan previously extended to such pledgors by LydianPrivate Bank. In addition, each such pledgor and Mr. Textor have executed aguaranty of the Lydian Loan in favor of Lydian Private Bank. The Lydian LoanAgreement and the Lydian Note contain customary events of default for facilitiesof this type; upon the occurrence of any such event of default, Lydian PrivateBank shall be entitled to all rights and remedies available to it against theCompany under law and the Lydian Loan Agreement and the Lydian Note, including,without limitation, the right to accelerate and demand immediate repayment ofall sums due thereunder.

**Note 18 — Subsequent Events**

***Strategic Alternatives***

          On August 14, 2006,BabyUniverse announced that its Board of Directors decided to begin a process toexplore strategic alternatives to enhance shareholder value including, but notlimited to, the acquisition of a substantial private company, the acquisition ofa complementary public company or a potential sale of the Company. On October 5,2006, the Company announced that it had retained Banc of America Securities LLCas its financial advisor.  There can be no assurance that a transactionwill result from this process and the Company does not intend to disclosedevelopments regarding its exploration unless and until the Company’s Boardof Directors has approved a specific transaction.

          On March 13,2007, the Company entered into a definitive Agreement and Plan of Merger (the“Merger Agreement”) with eToys Direct, Inc. (“eToysDirect”), an e-commerce and direct marketer of toys and otheryouth-related products.  Under the terms of the Merger Agreement, which hasbeen approved by the Company’s Board of Directors, the Company willexchange shares of its Common Stock, par value $0.001 per share (the“Common Stock”), for all the outstanding shares of eToysDirect.  Immediately following the merger contemplated by the MergerAgreement (the “Merger”), BabyUniverse shareholders at the timeimmediately prior to the Merger will own approximately one-third, and eToysDirect shareholders at the time immediately prior to the Merger will ownapproximately two-thirds, of the outstanding Common Stock.

          The Companyand eToys Direct have made customary representations, warranties and covenantsto one another in the Merger Agreement.  Consummation of the Merger issubject to certain conditions, including, among others, the approval of theMerger Agreement by the holders of the Common Stock, the repayment by theCompany of all of its indebtedness for borrowed money outstanding as of theclosing of the Merger, and the absence of any law or order prohibiting theconsummation of the Merger. The Merger Agreement contains certain terminationrights for both the Company and eToys Direct, and further provides that, upontermination of the Merger Agreement under specified circumstances, the Companymay be required to pay eToys Direct a termination fee of $1,567,178, andreimburse eToys Direct for the expenses incurred by it in connection with thetransaction in a maximum amount of $1,500,000.

F-30

**Exhibit Index**

21.1

Subsidiaries of   Registrant

 

 

23.1

Consent of Singer Lewak Greenbaum & Goldstein LLP, Independent RegisteredPublic Accounting Firm

 

 

23.2

Consent of Lieberman & Associates, P.A., Independent Registered PublicAccounting Firm

 

 

31.1

Certification by John C. Textor, Chief Executive Officer, pursuant to Section302 of the Sarbanes-Oxley Act of 2002

 

 

31.2

Certification by Michael Hull, Chief Financial Officer, pursuant to Section 302of the Sarbanes-Oxley Act of 2002

 

 

32.1

Certification by John C. Textor, Chief Executive Officer, pursuant to Section906 of the Sarbanes-Oxley Act of 2002

 

 

32.2

Certification by Michael Hull, Chief Financial Officer, pursuant to Section 906of the Sarbanes-Oxley Act of 2002

E-1************ |
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